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Hatteras Financial Corp. (NYSE:HTS)

Q1 2010 Earnings Call Transcript

April 28, 2010 10:00 am ET

Executives

Mark Collinson – IR, CCG Investor Relations

Michael Hough – Chairman and CEO

Ken Steele – CFO, Secretary and Treasurer

Ben Hough – President and COO

Fred Boos – EVP and Co-chief Investment Officer

Bill Gibbs – EVP and Co-chief Investment Officer

Analysts

Jason Arnold – RBC Capital Markets

Daniel Furtado – Jefferies

Mike Widner – Stifel Nicolaus

Mike Taiano – Sandler O'Neill

Henry Coffey – Sterne, Agee

Bose George – KBW

Steve Delaney – JMP Securities

Matthew Howlett – Macquarie Capital

Gabe Poggi – FBR

James Shanahan – Wells Fargo

Operator

Good morning, and welcome to the Hatteras Financial Corp's first quarter 2010 earnings call. All participants have been in a listening only mode. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Mark Collinson. Please go ahead.

Mark Collinson

Thanks, Linnia. Good morning, everyone, and welcome to the Hatteras Financial first quarter 2010 earnings conference call. With me today as usual is the company's Chairman and Chief Executive Officer, Michael Hough; the company's President and Chief Operating Officer, Ben Hough; and, the company's Chief Financial Officer, Ken Steele. Also available to answer your questions are the company's Co-Chief Investment Officers, Bill Gibbs and Fred Boos.

Before I hand the call over to them, please note that on this call, information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are subject to risks, uncertainties, and assumptions. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, expected, estimated, or projected.

The following factors, among others, could cause actual results to differ materially from those described in the forward-looking statements. The company's limited operating history, changes in its business and investment strategy, changes in interest rates, interest rate spreads, the yield curve or prepayment rates, changes in economic conditions generally, inflation or deflation, availability of certain opportunities, availability terms and deployment of capital, the degree and nature of the company's competition, general volatility of the capital markets, dependence on the company's manager and the company's ability to find a suitable replacement if the manager were to terminate its management relationship, and other factors that are set forth in the company's most recent annual report on Form 10-K filed with the Securities and Exchange Commission and any subsequent reports on Forms 10-Q and 8-K.

The content of this conference call contains time-sensitive information that is accurate only as of today, April the 28th, 2010. And the company undertakes no obligation to make any revisions to the statements contained in these remarks, or to update and to reflect the events or circumstances occurring after this conference call.

That's it for me. It's my pleasure to turn the call over to Michael Hough.

Michael Hough

Hi, good morning. Welcome to our first quarter call. As usual, our entire senior management team is here to answer any and all questions you may have about our first quarter results. But first we'll present some prepared remarks that should help answer some of your questions and give you a good up-to-date picture of our operations.

Quarter-end March 31st was to mark an eventful period in the Agency MBS market. As many predicted significant spread and price volatility to occur as the Federal Reserve terminated their MBS purchase program. Their support of the mortgage market appears to ultimately have been successful as they were able to drop spreads tighter and somewhat stabilized the US housing market.

In the expectations that spreads were going to widen and MBS prices would fall because of the Fed exit have, to date, been wrong. Relative spreads have tightened and prices on the short end of the curve have been traded higher. Hybrids, in particular, have maintained an extremely strong bid and prices on some parts of the coupon stock have kept rising and remained prohibitive as a long term investment option for us. However, our view is that since the Fed has stopped buying, much of the strong bid can be attributed to the government’s recent foray into our market with aggregate purchase by the GSCs of delinquent loans out of our securities.

We will discuss this on more detail. But along with the impact from the short term prepayment ramp comes a sizable amount of cash that will go directly back to the purchase of Agency MBS, temporarily offsetting the demand vacancy created by the Fed's withdrawal. Our short term view is that we expect the bid side to remain strong as (inaudible) is in need for many financial institutions. We have seen the demand for it continue to grow.

Our slightly longer term view is that as this new cash gets reinvested, we should expect more volatility in our market and more investment opportunity. We like our current leverage range and the flexibility that comes with it, especially in less certain times such as now, it puts us in a strong position to be able to quickly exploit opportunities as they arise.

For an example, the recent discussions surrounding how the Fed, at some point, will have to un-line their investment as one to play – to pay close attention to. We think this is a difficult proposition for them and wouldn’t happen any time soon. But our thought is that it could become ultimately be beneficial for us because when this happens, the long end of the yield curve would likely be most affected, which will then serve to make the mortgage yield curve steeper. Mortgage yield curve is steep right now, which hasn’t had counter-productive additional steepening will likely be an investment opportunity for us as hybrid prices should adjust as well.

We continue to (inaudible) the hybrid on part of the curve, while some of our older vintage paper has been subject to GSE buybacks. For the most part, that paper is much more valuable to Hatteras by holding it for the long term than it would have been by replacing it. However, there were Fannie pools we did sell and replace because their underlying characteristics led us to the conclusion that their exposure to the upcoming buyout was excessively high.

Most of these types of paper we purchased in early 2008 during the height of the market disconnect at prices that are some of the cheapest we own. These yields have been exceptional since then. And the buybacks represent a little catch up in a single digit CPR wins over the prior quarters. These yields are irreplaceable today, and we prefer to hold on to them.

What is interesting to us is how this paper, subject to ramp up prepayment, has held its value. Shortly after the announcement of bids out on hybrids, (inaudible) alike backed off a point or two, but rebounded quickly to even higher prices, especially when settling after the most factor dates, even to the point that we’ve seen higher coupon hybrids amazingly trade off to 107-plus handles. Again, the demand for this paper remains very strong. And reinvesting into high premium hybrid paper doesn’t provide a good risk reward profile in our view. This is why we continue to focus on current coupon paper, and why our average dollar price consistently remains relatively low.

Reinvesting the cash flow we're getting from prepayments is our challenge right now. We and many others are currently in a very liquid position and are competing daily upon good investments. As has been the case for a while, we continue to find the most relative risk-adjusted value in current coupon hybrid ARMs. Hybrids serve a great role in our long term strategy.

Not only do they provide a short initial duration and less duration drift and extension risks than do most of our other investment options, they stepped down the duration curve on a daily basis in tandem with our hedges, and hopefully with the interest rate cycle. This focus has resulted in the portfolio with laddered asset cash flows balanced well against laddered liabilities.

Interest rates in general have been range bound for months if forecasts for Fed policy changes keep it – pushed it out further. We like where we have taken our mix of assets and liabilities today and view Hatteras' risk reward profile to be positioned appropriately in light of all the certainties and uncertainties that we see. We have been shrinking the overall net risk exposure of our balance sheet steadily since we built the initial portfolio. And we have recently closed this gap to its tightest to date.

In summary, our belief is that focusing on this dynamic relationship within our balance sheet is the most (inaudible) generate consistent recurrence in changing interest rate environments. This is where the value lies in our portfolio. And we know that a spread-focused approach to risk management works in the best long term interest of our shareholders. We do not fill our mission and weren't sacrificing the future in exchange for current return.

So with that, I’ll hand this to Ken, who will go over our financial results for the quarter.

Ken Steele

Thanks, Michael. Good morning, everyone, and thanks again for joining us on the call today. I'll quickly go over this quarter's numbers and provide some brief discussion of the trends in operations that were evident in the first quarter of the year. Overall, the operating fundamentals of our strategy continue to be quite strong.

Our net income for the first quarter of 2010 was $43.7 million or $1.21 per share, a decrease from $46.3 million or $1.28 per share for the fourth quarter of 2009. This decrease was essentially the (inaudible) of the Freddie Mac buyback of delinquent loans that occurred in March. As you will hear, this program has created some static in our quarterly numbers that will carry over into the second quarter as well.

Then we'll give you specifics in a minute, while I will just mention the financial implications to the first quarter. At March 31st, 2010, our portfolio of MBS was $6.8 billion with a dollar price of $101.55 and coupon of 4.76%. Decreasing slightly from December 31st portfolio of $7 billion were the coupon of 4.86% due to the Freddie repurchases, our portfolio yield compressed more than our coupon, which only decreased 10 basis points.

Our yield for the quarter was $4.10 billion [ph], falling 33 basis points from 4.43% in the fourth quarter. Amortization expense rose to $9.2 million for the quarter due to the Freddie buyback, up from $6.2 million for the last quarter of 2009. This increase of merely 50% came mostly from the buyback, although we did have slightly more earning assets throughout the quarter. Our repayment rate for the first quarter was 36% on an annualized basis, a significant rise from the fourth quarter rate of 22.7%.

Across the funds, again, fell slightly despite the continued addition of interest rate swaps to our liability portfolio. The overall cost of funds went from 1.53% in the fourth quarter to 1.51% in the first quarter, a decrease of two basis points. This led to an interest rate spread of 259 basis points, a 31-basis point decrease from the fourth quarter spread at 290 basis points.

Our G&A expenses will allow then a norm of $3.1 million or an annualized rate of 131 basis points for the quarter. Our book value remained relatively constant as upward price moves experienced in the fourth quarter on our MBS remained in place despite the uncertainties surrounding Fannie and Freddie. Our MBS strengthening value, but this was offset by the following value of our interest rate swaps.

A book value at the end of the first quarter of 2010 was $25.48, and from the year-end number of $25.74, a 1% decrease. The components of our book value at March 31st, 2010 on a per share basis are $21.32 of permanent book, $0.24 of undistributed earnings, $5.25 of unrealized gain on our MBS, and an unrealized loss of $1.33 in our swaps. Our leverage fell slightly with a debt-to-equity ratio at quarter end of 6.6 to 1, compared to 6.8 to 1 at December 31st, although our equity decreased slightly for the quarter with smaller repo position than December 31st, reflecting a smaller portfolio post the Freddie repurchase activity.

In summary, we declare the dollar, a dividend of $1.20 for the first quarter and generated the yield and return on 18.6%.

I will now turn the call over to Ben for details regarding the portfolio.

Ben Hough

Thanks, Ken, and good morning. The Hatteras investment portfolio totaled $7.1 billion, including forward settling purchases on March 31st, up from $7 billion on December 31st. Given the mostly one-way nature of this market over the past five quarters, portfolio activity in the first quarter continue to be focused mainly on looking for relative value in the ARMs sector and replacing run off from prepayments to maintain target leverage. It’s the same premiums on hybrid ARMs, coupled with our view of potential upcoming opportunities. We’ve been reluctant to (inaudible) ahead of the buybacks.

We had much of the first quarter run off reinvested in December and January by buying toward new ARM production. And we ended the quarter with only slightly lower leverage than we reported at year-end. This enabled us again to generate solid earnings, even with the increased amortization expense associated with the Freddie Mac buybacks.

I'd like to share a little color on our experience with Freddie Mac loan repurchases. First, though, it's important to note that at about 75% of our portfolio was invested into more recent vintages less subject to delinquencies. That said, based on Freddie’s published tables, which were included in our last earnings release, we went into March with the expectation of realizing about $220 million in buyback-related prepayments. While it is impossible to know what were loan repurchases versus other prepayments, our best estimate is that it came in at about $170 million.

It was a manageable number and came in better than our expectations. Any book value impact was more than offset by the subsequent increase in value of the newly purchased securities and in other more recent vintage securities we own.

Looking ahead to the scheduled in Fannie Mae buybacks, this should also be manageable. Using their own published expectation tables, it appears that the majority of them will likely come in June for Hatteras, and some will be a second quarter of that. Our expectation is that a total of about $280 million of our Fannie Mae ARM loans are buyout candidates, with $235 million of that in the 5% to 6 % coupon bucket slated for buyback in June with the remainder beginning in July.

If you combine those with the approximate $170 million Freddie Macs already removed, we’ll be looking at a total number of around $450 million or about 6.5% to 7% of our December 31st portfolio, again, within our expectations. Eventually, with the bulk of the GSE loan buyback uncertainty having been removed, our remaining assets should perform more in line with expectations and provide above market long term yields for the portfolio.

As you know, we present prepayments as an actual annualized percentage rate, and the average rate’s 36%, which would equate to approximately 31% if converted to a constant prepayment rate or CPR. The percentage prepayment rate ranged from 23% in February to 54% in March driven by Freddie buybacks. In April we had a 34% prepayment rate, which we attribute mainly to continued GSE activity. We don’t expect post-buyback prepayments to remain elevated. And once the dust settles, we expect these securities to move to trend prepayment levels and continue to perform well for us given the low prices and high yields we originally booked.

To update investment activity in the current quarter, for the most part, we still see the best trade-off between yield, interest rate risk, and prepayment risk in new production hybrid ARMs. We have been focusing on this segment of the MBS markets since early ’09 and we will likely continue to until we see better all-in value elsewhere. In April, we settled $286 million. In May, we are currently slated for $102 million, and about $178 million each for June and for July, for a total of about $744 million, which assuming we don’t add more and depending on prepayments, should keep our portfolio size similar to where we were at the end of the first quarter.

Couple of quick notes on the liability side, repo rates have followed LIBOR and other short term rates, and recently migrated to the mid-20 basis point range, which is a few basis points higher than it was for most of the first quarter. Repo availability is increasingly favorable. And we continue to see a few counter-parties selectively reduce haircuts [ph] to attract new repo.

On hedging, we added $300 million additional interest rate swaps in the first quarter with the weighted average pay fixed rate of $251 and an average maturity of 51 months. Our total swaps booked and outstands a $3.1 billion notional, with an average pay fixed rate of 2.65% and a maturity of 28 months. This represents about 51% of our repo book at quarter’s end. Combined with the $400 million extended repo positions we already have, we have about 56% of our repo book, extended 26 months at a rate of 2.69. A large portion of our higher cost swaps we put on when we initiated our first two capital raises in ’07 and early ’08 comes due over the next 12 months, which will likely be replaced before maturity and will extend the average term of our total swaps booked further and also reduce the average cost.

Michael Hough

Okay. That concludes our introductory remarks. And we can now open this up for any questions you may have.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator instructions) At this time, we will pause momentarily to assemble our roster. And our first question is from Jason Arnold of RBC Capital Markets. Please go ahead.

Jason Arnold – RBC Capital Markets

Hi, good morning, guys.

Michael Hough

Hi.

Jason Arnold – RBC Capital Markets

First, I want to say congrats on the strong performance this quarter and for sticking with your investments rather than selling. Certainly, things have paid off very, very well here with the buyouts. Just a couple of quick questions, could you talk about what you’re seeing from the new production side come out of the GSEs and then specifically, perhaps comment on where specifically you see value on the hybrid ARM into the equation right now?

Michael Hough:

Sure. Good morning, Jason.

Jason Arnold – RBC Capital Markets

Good morning.

Michael Hough

As far as what we’re looking at right now, you’re looking at about 3.5 and 360 coupon-type paper. What we’re doing is, like we’ve been doing for the last year or so, looking to sell these securities forward to get the dollar price down. When we sell them forward about two months, it gets to see yield of about 320. And there’s plenty of production right now. We’re looking around $5 to $6 million a month.

Jason Arnold – RBC Capital Markets

Has that increased recently relative to what we are seeing in the recent half?

Ken Steele

The previous month in March was a little bit light. But prior to that, for the previous quarter, was pretty much in the $5 billion range.

Jason Arnold – RBC Capital Markets

Okay. And then one other question on you’re $800 million notional swaps maturing during 2010, are those staggered over the remainder of the year or are they bullet maturities here at some point?

Ken Steele

Yes, they’re staggered pretty much throughout the year. We have some and the second quarter – a couple in second quarter and all the way out through the year. So we try to ladder them out always in order to not create any spikes in earnings or anything like that so they’re always laddered out in a pretty consistent manner.

Michael Hough

To match the asset cash flows.

Jason Arnold – RBC Capital Markets

Makes a lot of sense. Okay, perfect. Thanks, and again, congrats.

Ken Steele

Thank you, Jason.

Operator

The next question is from Daniel Furtado of Jefferies, please go ahead.

Daniel Furtado – Jefferies

Good morning, guys. Thanks for taking my questions, and congratulations on the quarter.

Michael Hough

Thank you.

Daniel Furtado – Jefferies

Couple of just quick questions here, looking at the – what is this – the 61 month-plus part of your portfolio, looks like that ran down pretty significantly. And you also had a corresponding increase in the 0 t0 36 months to reset portion. Was this just typical roll down as these loans age page or was there more of a strategic focus to push that duration down?

Michael Hough

Well, hey, Dan, this is Michael.

Daniel Furtado – Jefferies

Hey, Michael.

Michael Hough

Good morning. And this is the reason really that we do have our ARMs is the fact that they do walk down the yield curve and they cease it on monthly basis similarly to our swap season. And so, what you're seeing here is the increase on the shorter is we have not been buying short securities. Those are securities we have purchased have and now walked down the curve.

Daniel Furtado – Jefferies

Excellent, excellent. Thank you. And then just secondly, I don’t know how comfortable you are talking about this. But to the extent you are, have you given any thought to – if we get some weakness in the second quarter because of the Fannie buyouts, it doesn’t look like it’s going to be that big a deal and actually much less than we thought 90 days ago. But what’s your strategy in terms of the undistributed income and using that to bridge any minor shortfalls or have you not gone there yet?

Michael Hough

We have not gone there yet. That is something we will wait to see next quarter. We have $0.24 undistributed income that will have to be distributed this year at some point. But for how are we going to utilize that, we haven’t made any decisions yet.

Daniel Furtado – Jefferies

Perfect. All right, well thanks for the time.

Michael Hough

Thank you.

Operator

The next one is from Mike Widner, please go ahead, of Stifel Nicolaus.

Mike Widner – Stifel Nicolaus

Hey, good morning, guys, and congrats on a solid quarter.

Michael Hough

Thank you.

Mike Widner – Stifel Nicolaus

I just wanted to follow up on the Fannie buyouts, you mentioned, Ben, I think it was, that you expect about $280 million in prepays from that portfolio. Give me a rough estimate of the cost basis you guys have on those.

Ben Hough

Well, yes, we indicated on our last earnings call and I think we booked a lot of these securities back in ’07 and ’08, especially when the markets were destroying it. And we’ve had a lot of these high coupon securities at really low prices. I think on average, not to be exact, but it’s right around $101 million in the quarter. So they’re securities obviously that we want to hold on to, what’s left of them, and feel like they’re going to perform well. So I would use $101 million on the quarter as a benchmark.

Mike Widner – Stifel Nicolaus

Okay, that were figured. And any indication of – or comments so far with the April speeds worth CPRs relative to what you saw in the first quarter?

Ben Hough

Yes, well, I mentioned before, in April, we saw average – our total prepayment rate for the whole portfolio was 34%, which was indicative of some additional GSE activity. We don’t expect those speeds to stay elevated once all the dust settles and once the buybacks are behind us. But April was a little higher – at the high end of our range, but it’s not – it didn’t surprise us a bit.

Mike Widner – Stifel Nicolaus

Right. And then you guys had a small realized gain on sale this quarter, just – which was unusual for you guys. I'm just wondering if you could talk a little bit about what that was, what you sold?

Ben Hough

It was sold a few small pools that we have looked at. I’ll let Bill talk about the details. But those pools were targeted for really excessive buyouts, and it just made sense for us to get out of the way of all – of our entire portfolio, those were the only ones we identified that really made sense not to hold on to.

Bill Gibbs

Yes, Mike, when you look at those bonds, they had a pretty wide dispersion between the net gross swaps. And they were definitely candidates for fast speeds, so we decided to sell them at that time.

Mike Widner – Stifel Nicolaus

Okay. And so, any rough indication on the notional amount of those?

Michael Hough

That's about $29 million.

Mike Widner – Stifel Nicolaus

Okay. So pretty small group, because I was just trying to triangulate looking at your expected $280 million of prepays, which was in line with our prior expectations, but then I was wondering if the buyouts would take that down at all. So just one further question, actually, if you guys could comment maybe on leveraging, you’re down a little bit right now. But what conditions would you need to see to feel comfortable, potentially taking that a little higher or letting it run down even further so that you feel less comfortable.

Michael Hough

Well, I think we’ve made a point for a while that this is a pretty comfortable range to be in. And we will likely continue to be in this range until – until some of these uncertainties clear and we have a more clear picture maybe of what even interest rates are going to do. I think right now it's a very flexible and strong position for us. And I think there’s one that we’re going to – as soon as we get the prepayments reinvested, this is one that we’re going to keep likely in this range. What we’ve been doing it now for, this will be our third quarter, is basically keeping our cash flow invested and maintaining excess liquidity looking for opportunities.

Mike Widner – Stifel Nicolaus

Got you. Well, appreciate the color guys, and congrats on a solid quarter.

Michael Hough

Thank you.

Operator

Your next question is from Mike Taiano of Sandler O’Neill. Please go ahead.

Mike Taiano – Sandler O’Neill

Hi, good morning. So just a couple of questions, I guess first, just to make sure I’m clear. The premium amortization will that – is that affected or reflected in first quarter at all? Will you have also a higher premium amortization rate in the second quarter as well?

Michael Hough

Well, from the Freddies, it's all reflected in the first quarter. And the Fannies, as they occur, will be basically a second quarter event.

Mike Taiano – Sandler O’Neill

Okay. So the Fannies are not in the numbers yet.

Michael Hough

That’s correct.

Mike Taiano – Sandler O’Neill

Okay. And then just secondly, I guess you guys have – you have talked about the discipline you’ve maintained through this market where prices have continued to go up, given the fact that the GSE buyouts are basically, largely, going to be behind you in the next month or two, and I’d imagine you get more comfortable with prepayment pieces at that point. You're stuck to the $102 million, $102.5 price range. Any feeling that you may be willing to go beyond that especially with some of those strong technical factors behind the hybrid ARM market?

Michael Hough

Well, again, our largest risk that we feel is prepayment risk – prepayment speed risk. I really don’t know what’s going to happen in Washington, but – and anything could happen. They could remove loan price adjustment fees, streamline mortgages that could cost a spike in prepays, the reps and warranties, GSE may elect to put out more loans and give them back to the originators. A lot of these are just examples of things that could happen. And so bottom line is, we still are cautious on prepay risk that’s why our portfolio exhibits $101.5 million. We’re still comfortable with that. And we manage, as we've always said, for the long run. So we’ll probably stay in that range.

Mike Taiano – Sandler O’Neill

Okay. Great. And then just final question is, on the new purchases, I think in the last quarter you said the spread on new purchases was somewhere in the mid 2% range. Is that consistent with the ones that you had coming on over the next few months or is it migrated down into more into the lower 2% range?

Ken Steele

I think you could use in the mid 2% right now, between $240 million and $250 million.

Michael Hough

It all depends on how we hedge it, Mike. It's kind of the way we look about – look at it when we're replacing it as proportionately to the way our balance sheet is setup right now and since last quarter yields are down a little bit. But also, our net cost of funds would be, too, on a new – on new securities if put on the books were the same – the same proportion as our portfolio.

Mike Taiano – Sandler O'Neill

Great. Thanks a lot.

Operator

Our next question is from Henry Coffey of Sterne, Agee. Please go ahead.

Henry Coffey – Sterne, Agee

Good morning, and thank you for taking my question. The level of the detail you're presenting, by the way, is extremely helpful. So thank you. I just want to make sure I understand this correctly. The first quarter showed all the impact of Freddie's activity. And based on the data you shared with us, what happens in June is going to be slightly higher, but not dramatically higher than what already happened. And some are aware – instead of looking forward and – instead of assuming its static universe, it looked like you lost about 10 basis points a coupon, and then the rest of the rating drop in yield was attributable to accelerated payment speeds.

So should we – does this work this way that the Freddie portfolio now resets at a higher speed rate? And that portion of the business is fine, but clearly takes a knockdown. And so, on balance, your yields end up about where they were. In a static universe, everything in June looks like it looked in March or is there a further decline in effective yields because of either reinvestment issues or some additional impact of the amortization business? And then I have a – to the extent that you can address that that would be appreciated. And then I have just another question that's related.

Michael Hough

I mean as far as that goes, I think that – if I understand your question, the impact of – of having a 4.5% or a 5% bust coupon prepay, we're reinvesting that coupon in the 3.5% to 3.75%. So that coupon rate, as we get prepayments, even by us going forward, will continue to come down to whatever degree.

Henry Coffey – Sterne, Agee

So it's a prepayment challenge, but just in terms of the static portfolio – yield on the static portfolio. It's a March bump and a June bump. And then it's business. And then after that the primary challenge is reinvestment.

Michael Hough

That's correct.

Henry Coffey – Sterne, Agee

And then in terms of accounting for this, the March quarter, in essence, is based on your March experience and reflects only the events of March. Or do you change your estimates instead of readjust your targeted yields for both periods.

Ken Steele

No, we're just – we're just – if you're slighting that the hit in the quarter that it occurs.

Henry Coffey – Sterne, Agee

And then we'll hit in June. And then, the bigger – the remaining problem is the reinvestment issue.

Ken Steele

That's correct. So any remaining effect of whatever comes in, we will – come on as basically in the next quarter because we use the actual prepayment.

Henry Coffey – Sterne, Agee

And can you – is there a point in the market where you could start to add leverage to the business to offset this loss and get back to your current historical run rate? Or maybe that's asking for too much forward-looking. But is there a point where you start boosting leverage?

Michael Hough

The way we think about it if we're always looking for investment opportunities. But we're going to balance it with our risk philosophy and our current risk profile. So I think it's impossible to say what our plans would be other than right now we like where we are.

Henry Coffey – Sterne, Agee

Well, thank you. This is obviously working very well for you. And we appreciate your consistency.

Michael Hough

Thank you.

Operator

Our next question is from Bose George of KBW. Please go ahead.

Bose George – KBW

Hey, good morning, guys, good quarter. I have a couple of questions. One, I just wanted to touch on the increased hedging that's in your portfolio. Partly, it reflected the decline in the repos, the writing percentage. I was wondering if you could see this percentage grow as we – I'm sorry, decline as we see the portfolio half this size increase or could we see our hedging go up further as you position yourself for rise in rates. Can you just discuss the outlook for that?

Michael Hough

I think that I mentioned it in the opening that since we started our philosophy, and then as we migrated through the interest rate cycle, we were going to tighten down our gaps into the risk profile of our entire balance sheet as we – and that is what we have done. I think some of the securities that we're putting on are going to be slightly longer durations than what are (inaudible) portfolio is. And we're going to hedge that appropriately. But I think even as – even if and when we grow our portfolio, then I would expect that our hedging percentage would, at worst, be similar to what it is today. But we're going to look at it purely from our net interest rate exposure.

Ben Hough

And those we have – we did point out that we did have a lot of swaps ladder coming due over the next 12 months. So as those are replaced, the percentage would technically stay the same. But the duration on the swaps book as a total would go – would extend significantly as we put those out farther, and which would bring the hedged rate list profile in quite a bit. So percentage base may stay the same in that scenario, but it also – the interest rate profile would improve quite a bit.

Bose George – KBW

Okay. Great. And can you just give us an update on the duration gap on your portfolio?

Michael Hough

As that's a moving target, we have been – we've been inside of 1% for a while now. And we're tight inside of 0.5%. I've used that number, 0.5%, as an approximation.

Bose George – KBW

Okay. Great. And then just one other point on the prepayment, you mentioned that June's going to be a bump. After that, is it totally done? Or is there going to be a little bit of stuff left over in the third quarter as well from Fannie Mae buyouts?

Michael Hough

Yes, we expect there's a little bit of our lower coupon securities that – based on Fannie's table that could fall in July. And if we went strictly by their numbers, so assuming that they came in like they thought, there could be a tail of $40 million, $45 million falling in July. But again, we've seen a little bit of noise around the timing of these tables. And so we don't want us to quite put any fine lines on timing on this because apparently, it's – every pool of loans that we have can have different coupons that may fall in different buckets, compared to the average coupon of the entire pool. But that said, yes, we expect that there'll be a little tail in July at this point.

Bose George – KBW

Okay. Great. Thanks again.

Michael Hough

Thanks.

Operator

The next question is from Steve Delaney of JMP Securities. Please go ahead.

Steve Delaney – JMP Securities

Thanks. Good morning, gentlemen. Pretty much everything I had is – has been covered and clear, just one point of clarification on the term you used, the proportionality. Ben, that was really good detail on the Fannies versus the Freddies. And I guess, this very simple logic is – see if I'm thinking clearly on this. In the first quarter, you're amortization bumped about $3 million from 4Q from – to $9.2 million from $6.2 million.

So if we attribute the $3 million increase largely to the Freddie buyouts, and whether it's second quarter or whether it's July, you're talking about $280 million for Fannies versus $170 million for Freddies. And that would give us a simple relationship of 160%. I mean if we just applied something around 160% to the $3 million increase, are we in the ballpark as far as the way the expense? I know you're not giving guidance here. But does that – is that a logical approach?

Ben Hough

Yes. I think using the back of the envelope I think that's reasonable, yes.

Steve Delaney – JMP Securities

With most of that – most of it is in the second quarter. But maybe we've summed for the 23% – 20%, 25% of that maybe to fall in the third quarter.

Ben Hough

Yes, it's possible. But again, the expectations are not exactly what seem to be coming from a timing standpoint. So it would have to be – you'd have to take that as a piece of estimate and it could fall either way.

Steve Delaney – JMP Securities

Yes, okay, meaning if they come quicker or a little bit later is what you're saying. It's not precise. I got it. Okay. And guys, the only other thing, you sold a few shares. I mean not a lot. But I don't know whether they were sold or restricted stock, whatever. But the shares increased by about 300,000. Are you using your continuous offering, or as the money planned, modestly invest something that you would – you would continue to do going forward once the attractiveness of the MBS market improves?

Ben Hough

Yes, that was the result of utilizing the CEO plan with candor. And we've always said we're going to use that plan optimistically. Our view is that there's a good chance in the near term that we do see some opportunities. And what we did in the first quarter really was just a test run. We had an opportunity to sell stock accretively. And the amount that we did was a limit that we put on, and we just wanted to understand how it worked, how we could access the market if we needed to. So attribute what we did at the test run and going forward is going to depend on the opportunities we see.

Steve Delaney – JMP Securities

Great. And that's about a – that's about a 2% cost issue there?

Ben Hough

In that ballpark.

Steve Delaney – JMP Securities

In that ballpark. Thanks a lot, guys.

Ben Hough

Thanks.

Operator

Our next question is from Matthew Howlett of Macquarie Capital. Please go ahead.

Matthew Howlett – Macquarie Capital

Well hey, guys. Thanks for taking my question. Would it be possible to get a little more color on dollar price in the new – on the new purchases when you buy coupon down in the forward market? And how much of that take off the dollar price are you buying steps, sort of $102 million on that current coupon buy-ones [ph]?

Ken Steele

You're pretty accurate right there. If you look at approximately a 3.5% new production bonds, I would assume around eight ticks a month is going to be the drop. So that would take you down into around the $102 million range.

Matthew Howlett – Macquarie Capital

Got you. It definitely appears to get better execution that way. And then just on the long term prepayment, what are you assuming? Is it a typical 20, 25 CPR you put on that, and you feel pretty good that coupon would perform if the speed was faster or if there is some extension on the bond?

Ben Hough

On a new production paper, I would use lower than 25.

Matthew Howlett – Macquarie Capital

Okay.

Ben Hough

Yes, you're definitely going to use something much lower than 25.

Matthew Howlett – Macquarie Capital

Got you. And then, the higher coupon, you mentioned that's too expensive for your rate now at $105-plus dollar prices. Remind us again what you use for relative value. Do you look at the – do you use OES? I mean it looks cheaper on that basis. Or you're just concerned what the unknown – the government's doing something, whether it's starting a (inaudible) and trying to get that working again. Did that keep you from going up in coupon? We've heard some of your competitors look at the low loan balance as the way to pretend – prepping this call risk. I guess the question is what would you like to see before heading up in coupon or getting – going up for your season pool – going up the season, the MBS?

Michael Hough

I mean Fred made the point earlier. We're in the business. All of us are in the business of managing risk. And with these types of securities, the only risk we really are unable to hedge is the prepayment risk. And our defense against prepayment risk is by buying lower dollar priced paper. And we have – we've done this business. We're in our twelfth year running an agency rate, Hatteras for two. But we understand the dynamics of that. And we have found that it's just much more effective from the long term performance of our portfolio and our company. It's going to do better if we really focus the dollar price down the best we can.

Fred Boos

This is Fred. I would also add. We always look at OES – LOES [ph] LIBOR options as it spread. We don't feel the pickup in higher coupons as that dramatic to (inaudible) to go up that high as well. I mean there's a technical reason for that. But as Michael just explained, that's our long run objective is to keep the premiums low. And we think that's a viable and optimal alternative for performance over the long run. We underscore over the long run.

Matthew Howlett – Macquarie Capital

Right, got you. Understood, I think there's a lot of risk on the higher coupon and the LIBOR uncertainty. And then last question, just looking at supply and demand, does it (inaudible) the hybrid arm production up. When you look at on the demand side, the government, they haven't announced if they could sell some of the – on what the – the $1.25 trillion (inaudible). I mean do you think it's realistic that they could sell at some point? And then what about – what are you seeing from the banks? Have they been sellers of some of the high coupon? Or what's their appetite like for the new issue stuff coming out? Are they backing away with some better loan growth?

Ben Hough

I'll take the said selling part of the question. Maybe Bill can address the other part. The Fed policy makers are vocal and they acknowledge that their discomfort with the $2-plus trillion balance sheet. If you look at Frankie's remarks, their timing is more a function of the strength of the overall economy and the housing sector recovered, in part the mortgage origination curve because the 30-year origination rates moved too dramatically north. The Fed's obviously not going to interfere. So our likely event would be next year, with a gradual pace and with the Fed getting very flexible in terms of its volume of sales and its market timing.

Matthew Howlett – Macquarie Capital

Right. I would agree. And then just on the bank demand?

Bill Gibbs

As far as bank demand is concerned, we're seeing extremely strong bank demand, particularly in the new issue paper. They're trying to get their average dollar price down as well. And they've been very active participants in the new issue market.

Matthew Howlett – Macquarie Capital

Would you say that possibly could let up if there's loan growth that's starting on the commercial side or something? Has it been more than – that's been more than normalized times?

Ben Hough

Yes, I would think if loan and demand picks up and have other alternatives, it would definitely look to do that and pull back a little on hybrids. But the way it extends right now, this is from what we've seen, there hasn't been a great deal of loan demand. And they've been looking for a short duration out that's been climbing into the hybrid market.

Matthew Howlett – Macquarie Capital

Right, exactly. Okay, guys. Great. Thank you.

Ben Hough

Thanks.

Operator

Our next question is from Gabe Poggi, FBR. Please go ahead.

Gabe Poggi – FBR

Hey, good morning, guys. Thanks for taking the question and nice quarter. Quick question to follow-up on the previous questions regarding the forward market. How has that supply trended as evidenced by your forward settles, you guys are actively in that market. Do you think that you'll be able to find that – really what I'm getting at is – is banks are in there buying now, it's obviously highly competitive. Do you feel comfortable that you'll be able to, as the bonds are attractive – if they're attractive, you'll be able to actively participate?

Ken Steele

Yes, Gabe. As far as production is concerned, it's been running about $5 billion to $6 billion a month. March was a little bit light. But over the last, probably, quarter or two, it's been running about $5 billion to $6 billion. So we believe there's enough – ample supply there to meet our needs, to reinvest our cash flows.

Michael Hough

Think about the shape of the mortgage yield curve now, it definitely has enough slope to incentivize borrowers and its ARMs are on a portability product again in a good way. And as long as this curve stays steep and with the possibility that it gets even steeper, we expect production's going to be pretty good.

Gabe Poggi – FBR

Right, Thanks so much.

Operator

Our next question is from James Shanahan of Wells Fargo. Please go ahead.

James Shanahan – Wells Fargo

Good morning.

Michael Hough

Good morning.

James Shanahan – Wells Fargo

Yes, my question relates to the – one of your earlier comments earlier in the call. I think you discussed that you had thought the Freddie impact would be $220 million in March. And by your estimate, it came in at $170 million. Is that correct?

Ken Steele

Yes, that's correct. We were simply putting our portfolio up on the tables they published and the $220 million number is what came out to us. And it turned out that based on our best estimates that they came in at $170 million. And again, we can't say exactly what's repurchase loan versus other types of prepayments. But that's why we came up with the $220 million and $170 million.

And again, the timing may not fall on the exact month that we think so there could be issues – timing issues on those tables, the way they were presented. But for the most part, as long as you don't take it as exact, that we feel like the general total number in the end will be similar to that.

James Shanahan – Wells Fargo

So that puts the core runoff rate then, sorting out this impact, kind of in the mid-20s or only slightly higher than September and December.

Michael Hough

Yes, I think so. I think that's – I think that's right on.

James Shanahan – Wells Fargo

So when you suggest that you think that after this Fannie Mae purchase activity ends in the June quarter that it normalizes to trends. Do you mean the 20% range or do you mean mid to high teens?

Michael Hough

I think that as a general trend over time, I think we've always said, in this market that we're in the 20% to 30% range. Hopefully, in the lower half of that on average over time. So, I think it could be in the teens – high teens at some point and it could spike significantly either way depending on how prepayments fall within our securities. But for a total, I think that I'd like to see it in the 20% to 25% range, but wouldn't be surprised to see it a little higher or a little lower.

James Shanahan – Wells Fargo

And one final question, please. Given what's happened with the – it's out of your control, obviously, this premium amortization expense and now the decline in the net interest spread. What is the outlook for the distribution?

Michael Hough

As far as dividend goes?

James Shanahan – Wells Fargo

Yes, sir.

Michael Hough

We're not going to give any real hard estimates on what we think dividends are going to be. But, this quarter, our dividend was about 20% and we're just going to have to see – we're just going to have to see how things play out on a quarter by quarter basis. However, the way we've looked at dividends, and we look at dividend distribution as our – as from a whole year – a whole year perspective. And we're just going to have to make those assumptions as we can.

James Shanahan – Wells Fargo

Okay. Thank you.

Operator

And gentlemen, I am showing no other questions at this time. I would like to turn the conference back over to Mr. Hough for any closing remarks.

Michael Hough

Okay. Thank you all for being on the call today. We really do appreciate your time and your interest in Hatteras. And we hope everyone has nice rest of the day.

Operator

Thank you.

Michael Hough

Thank you.

Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines.

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Source: Hatteras Financial Corp. Q1 2010 Earnings Call Transcript
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