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Anworth Mortgage Asset (NYSE:ANH)

Q4 2013 Earnings Call

February 12, 2014 1:00 pm ET

Executives

Joseph Lloyd McAdams - Chairman, Chief Executive Officer and President

Joseph E. McAdams - Chief Investment Officer, Executive Vice President and Director

Analysts

Daniel K. Altscher - FBR Capital Markets & Co., Research Division

Operator

Good afternoon, and welcome to the Anworth Mortgage Fourth Quarter 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded. [Operator Instructions] Before we begin the call, I will make a brief introductory statement. Statements made on this earnings call may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended, and we hereby claim the protection of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995 with respect to any such forward-looking statements. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as statement containing the words may, will, believe, expect, anticipate, intend, estimate, assume, continue or other similar terms or variations on those terms or the negative of those terms. You should not rely on our forward-looking statements because the matters they describe are subject to assumptions, known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control. Statements regarding the following subjects are forward-looking by their nature: our business and investment strategy, market trends and risks, assumptions regarding interest rates, and assumptions regarding prepayment rates on the mortgage loan securing our mortgage-backed securities. These forward-looking statements are subject to various risks and uncertainties, including those relating to changes in interest rates; changes in the market value of our mortgage-backed securities; changes in the yield curve; the availability of mortgage-backed securities for purchase; increases in the prepayment rates on the mortgage loans securing our mortgage-backed securities; our ability to use borrowing to finance our assets and, if available, the terms of any financing risks associated with investing in mortgage-related assets; changes in business conditions and the general economy, including the consequences of actions by the U.S. government and other foreign governments to address the global financial crisis; implementation of or changes in government regulations or programs affecting our business; our ability to maintain our qualification as a real estate investment trust under the Internal Revenue Code; our ability to maintain our exemption from registration under the Investment Company Act of 1940 as amended; and management's ability to manage our growth. These and other risks, uncertainties and factors, including those discussed under the heading risk factors in our annual report on Form 10-K and other reports that we file from time to time with the Securities and Exchange Commission, could cause our actual results to differ materially and adversely from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we do not intend to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Except as required by law, we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements that may be made today or that reflect any change in our expectations or any change in events, conditions or circumstances based on which any such statements are made. Thank you.

I would now like to introduce Mr. Lloyd McAdams, Chairman and Chief Executive Officer of Anworth. Please go ahead, sir.

Joseph Lloyd McAdams

Good morning, or good afternoon, ladies and gentlemen. I'm Lloyd McAdams and I'm welcoming you to this conference call in which we will summarize the company's recent activities and answer your questions about the past and the future during our question-and-answer session.

So first, let me briefly describe our recent results and then we will discuss our plans for the future. During the fourth quarter of 2013, Anworth earned net income to common stockholders of $9.7 million, which is $0.07 per diluted common share.

Stockholder equity available to our common stockholders at quarter end was approximately $829 million, which equates to a book value of $5.98 per share. This is based on approximately 138.7 million shares of common stock outstanding at December 31. This represents an increase of approximately 2% from our book value of $5.89 per share at September 30, 2013. The unrealized loss component of our AOCI, accumulated other comprehensive income, in our book value is $92 million, which consist of an unrealized loss on our MBS portfolio of $58.6 million, an unrealized loss on our swap portfolio of $33.4 million. This means that the balance of our book value, excluding this $92 million component, is $921 million or $6.64 per share, which loosely defines our book value estimate if all of our mortgage-backed securities repaid and all of our swaps matured.

Like to discuss briefly the income earned during the quarter and the details. During our fourth quarter, our net interest rate spread was 57 basis points compared to 82 basis points during the quarter ended September 30. This decline in the fourth quarter's interest rate spread occurred primarily as the result of the increase in our interest rate swap positions during primarily the third but also the fourth quarter's. At December 31, our average borrowing rate after adjusting for interest rate swap transactions was 1.50% compared to 1.44% at the end of the prior quarter.

Also at quarter end, the weighted average term to reset of our adjustable-rate agency mortgage-backed securities was 42 months. And after adjusting for interest rates paid through our swap transactions, the average term to interest rate reset of our liabilities was 1,010 days or about 34 months or almost 3 years.

During the quarter, the CPR portfolio, the prepayment rate, the agency mortgage-backed securities that occurred was approximately 15% annualized. The average amortized cost of our portfolio of agency mortgage-backed securities was 103.23%, which is a decrease from the previous quarter.

A few comments about our mortgage-backed security portfolio. The fair value of Anworth's portfolio of agency mortgage-backed securities at the quarter end was approximately $8.56 billion, which can be assigned to 4 broad categories of agency mortgage-backed securities. The first category would be ARMs, whose interest rates reset within the next year, within 12 months, that is 19% of our portfolio. Hybrid ARMs, whose interest rates reset between 1 and 3 years, is the second category, and that represents 24% of our portfolio. Hybrid ARMs, whose interest rates reset after 3 years, represents 36% of our portfolio. And finally, category 4, 15- and 30-year fixed-rate mortgage-backed securities which, I might point out, are predominantly 15-year securities, not 30-year securities in our case, these securities' interest rates, obviously, never reset and that represents 21% of our portfolio. As I mentioned, they are predominantly 15-year fixed-rate mortgage-backed securities.

A few comments about the financing of our portfolio, which I just described. The repurchase agreement financing of our Agency mortgage-backed security assets was approximately $7.58 billion at December 31, this is 8.1x our total equity, which consists of common stockholders equity plus all preferred stock and junior subordinated notes. At December 31, our floating to fixed-rate interest rate swaps were $5.375 million -- billion, excuse me, which represents approximately 71% of our outstanding repurchase agreement balance as of December 31. Our 19% of our portfolio consisting of ARMs, you may recall, it is category 1, which will reset within 1 year and, therefore, contributes very little to our portfolio's interest rate sensitivity. Our swap position is 91% of our portfolio, which excludes these category 1 assets, which will reset within 1 year. From a risk management perspective, I view this later percentage as a more informative measure about the margin of safety of our operation.

We should note that when determining the nature of prudent hedging strategy, we take into account the specific characteristics of each of these 4 categories of assets, which I've discussed. During the fourth quarter, our $5.375 billion of swaps increased in value by approximately $35 million, which was approximately 4% of our beginning common equity.

To talk a bit about our current position and plans. Our plans for now for our agency mortgage-backed securities portfolio is relatively unchanged from what we discussed here last quarter on this call. As I believe, many of you are aware, during the third quarter of 2013, we materially increased our swap positions that are used to hedge interest rate risk. The result was that our cost of borrowing increased significantly and that resulted in less net interest income. During our last conference call, we also describe our reasoning in reducing the interest rate sensitivity of the portfolio. Today, we still have those views, though they certainly can change, so I will not repeat them here. But if anyone wants to discuss this strategy in more detail thinking, during the question-and-answer session, we look forward to that.

Similarly, during our last conference call, we discussed the issue of our holding approximately $2.235 billion of interest rate swaps currently maturing in less than 3 years, which we acquired several years ago when interest rates were considerably higher. Declines in interest rates during the past several years have resulted in these swaps being carried on our books at about a $50 million unrealized loss. During the last conference call, we explained that we then intended to let the swaps mature during the next 3 years with the effect that the $50 million unrealized loss would, in fact, literally disappear at the swaps' maturity and the book value would be pleasantly higher by that same amount.

The flip side of this strategy is that these higher-than-current market interest rate swaps will, until they mature, continue to contribute to our higher-than-market cost of borrowing, which finances our current portfolio, thereby continuing to suppress our net interest income until they mature. Now the alternative, and it's a common alternative to this approach, is to close out the swaps, thereby turning the temporary unrealized loss into a permanent loss. The offsetting benefit of this is, of course, that net interest income would increase by the same $50 million over the next several years since the new market interest rate swaps would be lower by that same amount -- I guess I should say the interest rate on the new market rate swaps should be lower than that amount, thereby increasing our income. And probably important to note, as I guess most people just observed, the economic benefit to shareholders from both alternatives is basically the same. Relative to this, you have -- I mean, I have noted that during the fourth quarter, our swap position appreciated in value more than declined in the value of our mortgage-backed securities and this, of course, resulted in an increase in our total book value. A part -- at least I believe -- a part of this increase was the $50 million unrealized loss of less-than-3-year swaps being gradually reduced as the swaps approach their maturity, which is in less than 3 years.

Also, as we noted in our press release, during the fourth quarter and through yesterday, we have repurchased about 4.5 million shares of our common stock in what I think were attractive prices. Our newer mortgage-backed security investments financed at the current borrowing rates, which have a lower yield than our existing borrowing rate, might yield more during the next several years than the currently lower-yielding existing portfolio. But buying the existing portfolio, which is in effect what repurchasing your shares is, at the recent discount to its book value seem to have more than offset this.

Lastly, adding to my confidence about these repurchases is my belief that our portfolio is now considerably less volatile than it was last summer before we increased the swap hedging positions. We look forward to answering your questions and discussing any of these comments or discussing anything in our press release, which we issued yesterday, providing even more detail about our portfolio. So with that, we can now begin the question-and-answer session. Also here with me today is Joe McAdams, our Chief Investment Officer and a director of the company; Thad Brown, our Chief Financial Officer; and Chuck Siegel, our Senior Vice President of Finance. So now, we'll turn the call over to you, Andrew, and -- to begin our question-and-answer session.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Dan Altscher of FBR.

Daniel K. Altscher - FBR Capital Markets & Co., Research Division

There is a point that was made about the swaps that I thought was good about how some of the book value accretion or gain this quarter was from a portion of the swaps rolling off. Is there any way to size maybe how much that was? I mean, if memory serves me correctly, maybe the unrealized gain was maybe more, maybe $56 million or maybe even closer to $60 million last quarter. Now it's sounds like it's down to $50 million -- I'm sorry, unrealized loss from before.

Joseph Lloyd McAdams

I'll just make a comment. It's literally that the swaps maturity is getting shorter. And as maturity gets shorter, if interest rates are unchanged, the swaps will -- the unrealized loss will decline. And I have not calculated what the exact amount is, maybe Joe can comment on this also.

Joseph E. McAdams

Yes, Dan. This is Joe. I don't -- we don't have the exact number for the specific swaps that Lloyd mentioned. But in effect, what takes place and from the -- if you look at the table of our swap maturities, in effect, each quarter, the cash flows on any particular swap or any particular group of swaps is going to involve a payment of the fixed rate. If we're just going to look at the less-than-12-month swaps, that fixed rate is 2.07, net of 3-month LIBOR, which is currently around 24 basis points. So that net payment each quarter is, in effect, the amount of that negative mark-to-market that is going to be reversed out during a period of time, so the net of what the current market rate would be. And for the short -- for the short swaps, the current market rate would basically be almost on top of 3-month LIBOR. So in the case of the shortest bucket, almost the full payment made on those swaps is coming out of the negative mark-to-market. The calculation is a little more complicated for the longer buckets because, for example, the 2- to 3-year swap bucket where the average rate is 1.82, you'd have a market rate that would probably be 60 to 70 basis points. So it would be the amount of the excess payment over the current market rate is, in effect, what comes out of the mark-to-market. I hope that makes sense.

Daniel K. Altscher - FBR Capital Markets & Co., Research Division

Yes. No, that's perfect. And sticking with that part of the discussion. I mean, again, looking at the under 12-month remaining bucket for swaps, that's $410 million, looks like. When those actually do mature, is your intent to replace those swaps with the same duration or the same remaining tenure? Or is it kind of thinking to reload and say, well, that was maybe originally a 5-year swap and now, we have to put back on new 5-year tenure as opposed to putting on 1-year tenure at, say, 30 basis points.

Joseph E. McAdams

The closest answer would simply be to say those swaps will mature and they would only be replaced if the new swaps would be put on versus new investments that were being made with the P&I coming off of the portfolio. At the time we make investments, we put on swaps that we think will best hedge and manage both the cash flow and market value risk of the securities. Over time, those -- the reality can be different than our estimates. And in many cases, with some of these shorter swaps, given that we have, in previous years, had significantly higher-than-expected levels of prepayments, we actually haven't been at less of those remaining bonds that were purchased 3, 4, 5 years ago than we would have expected, although we still have basically the same overall swap balance. So there's not going to be -- there will be new swaps put on, but typically those new swaps are put on relative to new purchases. So both the assets and the liabilities are coming on to the balance sheet at current market rates.

Daniel K. Altscher - FBR Capital Markets & Co., Research Division

Okay. That's perfect. And then just one more, if I may. Understood that you all sound pretty happy, I guess, of where the portfolio is positioned more or less today and maintaining, I guess, more of a defensive stance. But is it you are thinking to maybe get even more defensive here and increase the swap load continually or reduce the overall duration on the asset side of the portfolio? Or is it kind of just static and status quo?

Joseph E. McAdams

Well, the duration of our portfolio at December 31 was 3.0 years. And I believe 2.8 years was the all-in sort of fixed rate period of our swap and repo position. So -- and that's pretty much unchanged from where we were at September 30. So we expect to continue to maintain a narrow asset-liability mismatch. Clearly, the market has improved over the last several months relative to where it was in the summer in terms of both overall interest rate volatility and the performance of mortgage -- mortgages versus swaps. That basis has been improving for us. I don't expect it to incrementally be adding more interest rate exposure by widening our interest rate GAAP. Again, just to sort of go back in time, at the beginning of 2013, we also had a very narrow asset-liability mismatch. And what took place during the year was as interest rates grow sharply, as mortgages underperformed other fixed income instruments, our interest rate GAAP widened significantly. And we went from having virtually no asset-liability mismatch to over a year of asset-liability mismatch on our existing portfolio. So these incremental swaps that have been put on have been to bring that GAAP back down to a low level, a prudent level, and one that we feel will best serve us going forward. So I don't expect any change in our asset-liability mismatch. One point I would make as we move forward is -- and I had alluded to that there's sort of 2 purposes of having an asset-liability and risk management program. One is to try to maintain a stability of book value by having a reasonably matched asset and duration -- asset and liability side of the balance sheet. And the other is to try to provide a relatively stable level of income if interest rates and financing costs were to rise and fall. So I do think the trend going forward, as we're slowly moving towards a place where we might see short-term interest rates rise again, with -- to try to be in a position where through the combination of prepayments on our portfolio and interest rate swap agreements, that we felt we were well protected against short-term moves in the short-term interest rates. And I think -- so I would expect the overall swap position relative to our repos to continue to sort of -- it has increased and I would expect it to continue to stay at a fairly high level as we move forward.

Operator

The next question comes from Stephen Sdutchlik [ph], a private investor.

Unknown Attendee

Yes. With regard to share repurchases, if you don't have enough CPR to fund this, do you sell existing mortgage-backed securities and swaps? And if so, does this change your discount-to-book value hurdle rate to repurchase shares?

Joseph Lloyd McAdams

I think the answer to the question is we have not obviously approached -- since we do purchase new securities each quarter, we've not reached the stage where we think that the entire cash flow of the company during the quarter would be best invested in repurchasing shares at some large discount. And so, the answer to the question is it doesn't seem likely to happen. But if it were to happen, clearly, and you thought it was worthwhile actually selling a security and realizing probably a loss to do that, I guess that's what would take place. But that has not happened and it doesn't seem likely that it would, but it could happen.

Unknown Attendee

Okay. And in a prior conference call, you made reference to legacy ARMs that had 1.75% margin upon reset. How much of these legacy ARMs are left in the portfolio? And can you give me some color on what the margins are on new purchases? And do you have an average margin for the entire portfolio?

Joseph E. McAdams

This is Joe McAdams. The margin of 175 basis points is the stated margin on the mortgage-backed security over the benchmark LIBOR rate. The portion of the portfolio that is in this process of being -- of resetting on an annual or more frequent basis, that has a reset of 1 year or less, is 19% of the portfolio. I would point out that those securities were not purchased at par and, in many cases, have a premium of approximately 3%. And so, the effective margin that we earn on those securities, net of the purchase premium as well as the amortization of that premium as those securities were to refinance, brings that margin over our financing costs to something definitely lower than 175 basis points. On the portfolio as a whole and new investments, this spread between the yield on our new investments, which include both adjustable-rate mortgages and fixed-rate, over our all-in financing cost is approximately 90 basis points. That -- and that's similar to where our portfolio as a whole would be if it were mark-to-market. Again, as we reported on a GAAP basis, this spread on our portfolio during the fourth quarter was 50 basis points. But a significant factor there, as we've made reference to already, was some of these shorter legacy swap positions that are significantly above market interest rates.

Unknown Attendee

But now, when you're making these new ARM purchases, are the longer ARMs, do they have a higher margin, like a 7-year versus a 3- versus a 5-?

Joseph E. McAdams

Typically, the margin -- while there can be different margins on different sorts of loans, you don't typically get a larger, again, I think, margin over the benchmark interest rate just because it's 5 years or 7 years to reset. When the ARM security resets to a floating interest rate, typically it's anywhere from a 1.5% to 2% would be the margin over the benchmark at that point.

Unknown Attendee

Okay. So the longer-rated ARMs, the benefit of that is you might be purchasing at a lower cost even if the margin is the same because you're taking more risk on a term?

Joseph E. McAdams

That's correct. Or in many cases, what you will see is the coupon rate during the fixed period is slightly higher for the longer fixed hybrids than the shorter hybrids. But the effect is the same, you're correct.

Operator

As I see that there are no other questions, this concludes our question-and-answer session. I would like to turn the conference back over to Lloyd McAdams for any closing remarks.

Joseph Lloyd McAdams

Well, thank you very much, everyone, for attending. And we are glad we had the opportunity to answer the questions. We look forward to meeting with you next quarter at the same time. Goodbye, everyone.

Operator

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

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