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Arlington Asset Investment (NYSE:AI)

Q4 2013 Earnings Call

February 04, 2014 9:00 am ET

Executives

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

Eric F. Billings - Chairman, Chief Executive Officer, Co-Founder, Chairman of FBR Capital Markets, Chief Executive Officer FBR Capital Markets and Chairman of FBR Asset Investment Corporation - Sub

Analysts

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

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

Trevor Cranston - JMP Securities LLC, Research Division

Operator

Good morning. I would like to welcome everyone to the Arlington Asset Fourth Quarter and Full Year 2013 Earnings Call. [Operator Instructions] I would now like to turn the conference over to Mr. Kurt Harrington. Mr. Harrington, you may begin, sir.

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, financial and business performance, market conditions, business strategies or expectations, 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 forward-looking statements are based on management's beliefs, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the company's annual report on Form 10-K for the year ended December 31, 2012; the quarterly report on form 10-Q for the quarter ended September 30, 2013; and other documents filed by the company with the SEC from time to time, which are readily 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 remarks.

Eric F. Billings

Thank you, Kurt. Good morning, and welcome to the fourth quarter earnings call for Arlington Asset. I am 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.

2013 was a strong year for our company. In the face of significant and abrupt increases in intermediate and longer-term interest rates over the course of the year, Arlington protected book value per share, posted $4.15 per share of core operating income or an 18% return on equity, expanded capital available for investment by a 1/3 and reduced the cash expense burden on capital by 15%.

For the fourth quarter of 2013, Arlington reported increased book value in core operating income of $0.97 per share. We feel great about Arlington's 2013 results, and we remain confident at the start of 2014; 65% of our investable capital is allocated to floating rate prime jumbo private-label mortgage-backed securities, where credit performance continues to improve based on strengthening in the U.S. economy and housing sector. As a consequence, expectations for terminal values on these securities escalated approximately 10% from a year ago and have continued to increase, driving market prices for these securities higher. Our agency-backed mortgage-backed security hedges are approximately equal in notional value with a goal of neutral to slightly negative duration. Access to funding has continued to improve for the company as well. Our roster of repo counterparties has grown 25%, and available capacity has increased for repo on both agency-backed and private-label MBS. Cash expenses as a percentage of investable capital declined by 60 basis points from a year ago, and as an internally managed company, there is further opportunity for leverage on fixed costs as we grow.

Return on equity could improve by 100 basis points over time as a result. The company has a share repurchase authorization in place. Finally, the company has approximately $200 million of remaining net operating loss carryforwards and $50 million of net capital loss carryforwards available for use in future periods, which means that at current earnings level, the company's tax-advantaged C corporation flexibility, 2% cash rate, and qualified C corporation tax treatment on dividends could extend until 2018.

Within the housing sector, U.S. Government housing policy continues to be a positive factor. In our view, while higher rates have slowed mortgage originations in home purchases, continued economic recovery -- continued recovery of company by positive job creation, high home affordability, somewhat lighter lending and appraisal standards in stabilizing home formation will support continued strong housing demand and ongoing decline in distressed loans, foreclosures and home liquidations over the course of 2014.

We expect these factors to contribute to positive performance in our MBS portfolio. In our private-label MBS portfolio, we have observed 6 months of linked reductions in serious delinquencies across the portfolio as they have declined from approximately 19% to 16%. Likewise, loss severities have declined from 46% to 37% over the last 6 months. The value creation from that process is being reflected over time in deleveraging of our securities, higher expected cash flows, increased terminal values and ultimately higher pricing. Capital allocated to private-label MBS at quarter end was approximately, $278 million representing approximately 65% of investable capital.

Capital allocated to agency mortgage-backed securities was approximately $166 million. Given the outlook for the U.S. economy, the Federal Reserve's papering of QE3 and normalizing interest rates, we continue to maintain an overall hedge position approximately equal to the market value of the company's agency MBS position. Our Eurodollar futures contracts we utilized to hedge our agency MBS portfolio run consecutively on a quarterly basis beginning in March of 2015 and extend out to December 2018.

On a mark-to-market basis, they have an average notional amount of approximately $1 billion with a rate of 2.26% and an equivalent funding cost over the next 5 years of approximately 1.74%. In order to extend the duration of our overall hedge positions to approximately match our MBS asset duration, at quarter end, we had 10-year interest rate swap futures that expire quarterly and which we expect to typically roll forward on a quarterly basis. They had a notional amount of $610 million with a mark-to-market average cost of 3.19%. While mark-to-market gains or losses can occur over time, to the extent mark-to-market hedge values are lower than funding costs on agency MBS will be lower for a longer period. With an asset yield of approximately 3.8% and a blended hedged funding cost of approximately 2.2% at year end, we continue to believe this structure allows us to earn an attractive spread and protect the value of our portfolio as the economy, monetary policy and markets normalize.

In the third quarter of our agency MBS portfolio demonstrated a 3-month portfolio CPR of 6.3% versus CPR of 8.5% on Fannie Mae fours [ph], fours [ph] coupon universe. Approximately 80% of our agency MBS portfolio was originated under HARP programs, and our remaining asset consists of either low loan balance loans or loans with other prepayment protection features.

At December 31, 2013, our private-label MBS portfolio had a fair value of 70% of face value, total market value of $341 million, and a repo of $63 million. OCI related to private label securities was $63 million as of December 31. The assumptions used to value the portfolio at December 31, 2013, included, on a weighted average basis, a constant default rate of 3.7% loss severity on liquidated loans of 45%, constant prepayment rate of 11.8%, and a discount rate of 6.5%. Looking forward to a point 2 years from today, we expect approximately 90% of our re-REMIC portfolio to be variable rate in nature and to insulate the portfolio from potential future increases in interest rates.

The expected overall terminal value of our re-REMIC mezzanine securities is approximately 20 points above our current price of 70, which on $486 million of face value would represent approximately $95 million of potential appreciation over time. Based on that expectation, the final total return outcomes on these private-label securities will be determined by the timely -- timeline to realization of the potential appreciation. Our view is that it will occur within approximately a 2-year period resulting in total annual returns on our private-label securities in the teens or better from their current price level.

Another way to think about this dynamic would be to assume for illustration purposes that the $278 million of current -- of capital currently allocated to our private-label mortgage-backed security portfolio were reallocated to the agency MBS portfolio at approximately a 15% return on equity on a hedge basis. Because, today, we recognize only the cash yield and earnings from realized gains on our private-label mortgage-backed security portfolio for core operating income, such a change in allocation would produce an increase in current hedge spread income, which would provide additional flexibility to potentially expand a dividend or accumulate capital given our C corp structure.

We believe that if the U.S. economy, employment and housing markets continue to evolve along their recovery path from the depths of the financial crisis, outside returns remain available in deep discount private-label mortgage-backed securities such as Arlington. Just as prices for these assets in recent years have risen with actual and expected improvement in economic and housing conditions, our view is that over approximately 12 to 24 months, private-label mortgage-backed security prices will rise to a point at which returns will have normalized and will flow -- will fall below Arlington's hurdle rate. With the expectation that the natural process normalization in private-label MBS securities returns will occur over time, we are constantly reviewing alternative investment opportunities, which can produce risk-adjusted returns that exceed and/or meet our threshold.

In the meantime, we continue to be optimistic about the company's opportunities. We have 2 complementary portfolios with attractive attributes in high risk-adjusted returns. The majority of our capital is allocated to floating private-rate -- private-label MBS securities with a discount price of 70% of par and a significant per share appreciation potential, our agency-backed MBS is substantially hedged, our leverage is low, and our funding capacity is increasing. Looking forward, ROEs will benefit from reduced expense ratio -- a reduced expense ratio to capital, and at current cash earnings level, our net operating loss carryforwards will remain available until 2018. Operator, I would like to now open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from David Walrod with Ladenburg Thalmann Financial Services.

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

Eric, just wanted to follow up on -- you spent the last few minutes talking about kind of the tipping point of where it makes more sense to be in agencies. In your press release, you talked about how in the month of January, you guys have added approximately $130 million in face value of agency MBS. Are we -- are you basically saying that we're kind of there now, and we should look for capital allocation to begin to skew more towards the [indiscernible]?

Eric F. Billings

Well, I mean, it's a natural evolution. It is a process which is going to evolve in our judgment over sometime, over the next 2 years. And so during that timeframe, you should anticipate an evolution to a greater and greater amount of the agency allocation. And it's purely price driven. And the way it manifests itself, really, if some part of the portfolio appreciates in price, they've given times, because we simply can -- we can barometer against the agency assets and our capital return there to the degree we're returning mid-to-high teens. We know that on the non-agency, we have to be able to achieve at least that amount. Clearly, there are advantages in the agency in the fact that the earnings are cash current now versus on the net non-agency, some part of the return does require the continued appreciation, which is in our judgment certainly quite inevitable just given the nature of paydowns and these back page becoming front page, naturally, over time anyway. So this is occurring, of course, pretty steadily, but some assets occur more rapidly than others, and in that regard, we then -- we harvest those when they no longer will meet that return, and we will then redeploy in the agency. But as we stated in the script, that natural process to the degree it would unfold, as our judgment indicates to us that it will, then to natural fruition, we would experience something in the vicinity of a $90 million to $100 million gain in the residual non-agency assets and quite simply, you would then take the totality of that capital and assume that it's redeployed in an agency structure again in a mid-to-high teens or whatever people's model are using. Those are ours, but at the current time, you can see quite clearly that will drive a higher earnings stream with the obvious opportunity to increase dividend and or just grow that the equity base. Last comment on this I'd make is, remember, it doesn't necessarily mean that we're going to see all of the $90 million to $100 million because, unless it happens quickly, we will end up coming out of the non-agency assets before you actually reach that level of full maturity because, clearly at that level, you would only be judging to receive a coupon return, and that would be far below what we can do in the agency. So somewhere in the 80 price range is 80 to 85 depending on the individual asset, is the generalization is where we are coming out of assets when the opportunity presents itself.

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

Okay. One other question just in relation to -- if you could just talk a little bit about the tax line, the reversal that went through there specifically, in your reconciliation, you talk about the reversal of the tax liability. Is that related to the state tax matter that you had accrued the expense for? And if so, is that now fully reversed?

Kurt Ross Harrington

Yes, Dave. Kurt Harrington here. Two questions here, the state tax on certain tax reserve that we had is fully reserved. That was reversed, I mean, reversed in the fourth quarter upon the statute of limitations expiring on that tax year. Secondly, the revision to the last year tax number has to do with the rate that's used in the deferred tax asset. Given where we are today and what our outlook is for the utilization of our NOLs, there was a slight change in that rate, and it gets pushed back into last year. It was a very immaterial amount versus the book value and the earnings in those periods.

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

Okay, and then, I guess just, the deferred tax asset on the balance sheet increased this quarter. Is that also to do with the revaluation?

Kurt Ross Harrington

That had to do with the utilization of our -- in capital loss carryforwards NCLs, and we're able, actually, to utilize more than we had expected when it was first set up a year ago.

Operator

Our next question comes from Jason Stewart with Compass Point.

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

First question on the non-agency portfolio. Were there any material changes in the composition during the quarter that would have caused cash yield to go up? I mean, were there any portfolio allocation changes?

Kurt Ross Harrington

Sorry, Jason, overall cash yield or within 1 of the 2 portfolios?

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

Well, specifically on the non-agency, yes.

Kurt Ross Harrington

There was no really significant shift.

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

Okay.

Kurt Ross Harrington

What's driving that question, Jason?

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

Well I just, I mean we didn't short rates move up much, and it looks like there was small sales occur, but the cash yield is -- it's 20 basis points higher. It is not a big difference but just wondering if there was any shifts in there.

Kurt Ross Harrington

No, there was nothing material going on there other than there were a couple of bonds sold and there might be a couple of bonds adjusting or something adjusting in there. But other than that, nothing. [indiscernible].

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

Okay, and then on the agency side, [indiscernible] which rates lower in 2014. I mean we've seen the coupon stack compress here. But we haven't noticed yet any increase in value for prepaid protected collateral like you own. Have you seen any difference in value there? Or has that started to pick up at all?

Kurt Ross Harrington

Not really. Maybe a touch, but not really. To the extent that we're going to happen it would need to demonstrate itself for a little bit of time before it gets realized. But I don't think we've seen anything significant there.

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

Okay. And then on the legacy litigation expense, can you remind me what was flowing through in the fourth quarter there. It looks like there was 510,000?

Kurt Ross Harrington

We had a matter that we settled in the fourth quarter.

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

And was it similar to -- was it the same matter, or were these -- this a new matter that -- I mean we had some...

Kurt Ross Harrington

It was a piece that had been ongoing through a part of the year at a sort of a very slow -- low boil, and without a lot of cost attached to it going in -- going through that exercise. And then at the end, we -- the 2 parties just agreed to settle it and move on.

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

So that would be it -- it's resolved?

Kurt Ross Harrington

It's resolved. Absolutely.

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

One last question.

Eric F. Billings

It was resolved in the fourth quarter.

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

Eric, you mentioned alternative investment opportunities. And I wonder if you could elaborate a little bit more on that on whether you were looking at opportunities outside of the agency MBS or non-agency MBS, and what you're thinking was there?

Eric F. Billings

Well, Jason to be clear, we at our core and our root an agency allocating capital company. And that I'm quite sure will always be the case and so significant amount of our capital will be there. Having said that, obviously, the team here has been around the allocation of assets and the investment business for a very long time, and we have seen just about every kind of asset that exists out there. So we feel like we do have broad skills that on a select opportunity will or may allow us to find opportunities to allocate capital where we think the risk-adjusted character of that could provide superior returns and, obviously, just as in at the non-agency asset class did in a very powerful way over the last 4 years. So it's really that, that thought, and we just want people to know that we are looking. We don't particularly have a view right now. It's just something that is particularly attractive to us outside the areas we're invested in, but we do monitor it all the time, and to the degree we're able to uncover something, then we would anticipate potentially participating in that regard. But it would be consistent with the character of the business, and it would wrap around something that we feel like we have very deep knowledge and understanding of, obviously.

Operator

[Operator Instructions] Our next question comes from Trevor Cranston with JMP securities.

Trevor Cranston - JMP Securities LLC, Research Division

One quick follow-up on the change to the deferred tax asset going back to last year. Is that also going to result in a change to the number you reported on the balance sheet for the first 3 quarters of this year? And if so, do you have the number as it was at September 30, handy?

Kurt Ross Harrington

Yes, Jason -- Trevor, yes. That shouldn't affect the quarters. It's -- when you look at the interperiod allocation, it's so small, it's under the radar.

Trevor Cranston - JMP Securities LLC, Research Division

Okay. Got it. And I guess switching to the non-agency portfolio. I think there was a comment about some of the pricing assumptions, I think you said the CPR you guys were assuming with something around 11.8 at a loss severity of around 45%. I guess those 2 numbers in particular struck me as being not quite as good as what the current metrics on the portfolio are. So I was just wondering if you could comment on, if you're expecting the improvements we've seen in terms of severity and some faster prepaid speeds [ph] to start to level out this year, or if it's just more case of, you're trying to be kind of conservative with the pricing assumptions you're currently using?

Kurt Ross Harrington

You know Trevor, the performance of the portfolio is pretty positive, and you can see that in pretty much every way, and I think that's the point we're trying to convey here. Having said that, as part of the valuation exercise for the assets in supporting the market price -- mark-to-market prices for these assets, you have to use market reports [ph] and different things, drawing information from a variety of different sources. And so, sometimes that -- those source are maybe a little bit more conservative than reality, and so that's sort of reflected here.

Eric F. Billings

[indiscernible], I mean it's really the latter is the answer, Trevor. I think the portfolio is performing quite a bit better than those numbers and have been pretty consistently now for years. And so, you should draw the natural conclusion there or whatever you think is suitable for your own anticipation. But it gives you a sense of how we're doing it.

Trevor Cranston - JMP Securities LLC, Research Division

Okay. Fair enough. And then last thing I guess, can you just comment a little bit on where you're seeing repo pricing right now versus where it was in the fourth quarter?

Kurt Ross Harrington

I wouldn't say it has changed a lot, but we did not really see a year end -- a really meaningful year end bump in rate as we have from time-to-time in prior years. And so there wasn't maybe as much room to come down in rate from those rates because they didn't rise as much. So I would say it's completely in line. I think, repo terms and rates have been in line sort of in the high 30 basis point range sort of [indiscernible] here.

Trevor Cranston - JMP Securities LLC, Research Division

That's helpful.

Kurt Ross Harrington

35 to 40 basis points right in that range, probably average around 37, 38.

Operator

Mr. Billings there are no more questions at this time.

Eric F. Billings

Thanks everybody for joining us. We appreciate it, and we look forward to speaking with you next quarter.

Operator

Ladies and gentlemen, that concludes today's presentation. You may disconnect your phone lines, and have a wonderful morning. Thank you.

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