Apollo Residential Mortgage's CEO Discusses Q4 2013 Results - Earnings Call Transcript

Feb.20.14 | About: Apollo Residential (AMTG)

Apollo Residential Mortgage, Inc. (NYSE:AMTG)

Q4 2013 Results Earnings Conference Call

February 20, 2014 10:00 AM ET

Executives

Michael Commaroto - Chief Executive Officer

Teresa Covello - Chief Financial Officer

Analysts

Steve DeLaney - JMP Securities

Mike Widner - KBW

Jason Stewart - Compass Point

Operator

Good day ladies and gentlemen, and welcome to the Apollo Residential Mortgage Fourth Quarter 2013 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time.

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

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

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

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

Michael Commaroto

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

2013 was a challenging year for the fixed income markets, and mortgage-backed securities market in particular. Constant uncertainty surrounding if and when the Federal Reserve will taper asset purchases coupled with [mixed] data surrounding the state of the U.S. economy, and rising interest rates led to increased volatility and caused record outflows from fixed income mutual funds. As a result, Agency RMBS underperformed as an asset class in 2013. Despite the ongoing volatility, AMTG ended the year with solid operating results, a diversified portfolio, and a stable book value.

Beginning in June, when the market disruption began, the company took decisive risk management steps to lower its leverage, rebalance its portfolio with a focus on credit assets, maintaining net duration gap close to zero. As a result of the company’s actions, AMTG ended the year with the portfolio equity allocation of 47% non-Agency RMBS and securitized mortgage loans, [44] (ph)% Agency RMBS, and 9% cash, and a leverage ratio of 4.1 times as compared to 5.1 times at the end of 2012. Book value per common share ended the year $18.26, reflecting a decline for approximately 1% from the end of Q3.

We believe that AMTG’ equity allocation is well positioned for the current market environment, which continues to show signs of volatility. When the Federal Reserve announced they would begin tapering in December, the initial market reaction was muted. However, the tapering news combined with increasingly strong economic reports drove the yield on a 10-year note over 3% at year-end only to be followed by a decline in rates through January with the 10-year note yield touching a low of 2.58% on February 4.

With this volatility in mind, in the fourth quarter, the company continued to redeploy capital into seasoned sub-priced floating rate RMBS. These assets have performed well due to market technicals driven by a shrinking investible asset base as well as market fundamentals driven by underlying strength in the housing market.

The key metrics in the company’s non-agency portfolio continued to improve in the fourth quarter with voluntary prepays staying above 4% CPR for the second quarter in a row, which we believe reflects higher home price appreciation and improved real estate market fundamentals.

Moreover, defaults gradually declined as we believe services had worked through their pipelines of delinquent assets, and accordingly (inaudible) stayed in the low-to-mid 70s. Our view on the housing market remains constructive. However, given the significant rally in the non-agency market during 2013, we believe it is important for AMTG to begin originating credit investments to complement the company’s strategy of investing in seasoned securities as yields on non-agencies have compressed.

We’re exploring several new credit initiatives, and we recently entered into a relationship to provide a loan to a third-party to facilitate the purchase of residential properties with a view towards reselling the properties to homeowners and taking back total financing in the form of mortgage loans or bonds for title, which we anticipate will be sold to us. We’ll provide update on this initiative as it progresses.

Finally, I wanted to point out that given the decline in interest rates and the rally in the pricing for RMBS that occurred subsequent to year-end, we have seen a positive increase in AMTG’s book value per common share to-date.

I would now like to turn the call over to Teresa who will review our financial results for the quarter. Teresa?

Teresa Covello

Thanks Michael. Turning to fourth quarter performance, AMTG reported operating earnings of $19.5 million or $0.61 per common share, and net income allocable to common stockholders and participating securities of $5.1 million or $0.16 per common share. For the full year ended December 31, 2013, AMTG reported operating earnings of $68.9 million or $2.26 per common share, and a net loss allocable to common stockholders and participating securities of $61 million or a loss of $2.02 per common share.

The company’s earnings release and supplemental information package, both of which are available in the investor relations section of our website contain a detailed reconciliation of GAAP net income to operating earnings.

As detailed in the reconciliation, the variance between GAAP net income per common share and operating earnings per common share for the fourth quarter primarily reflects realized net losses of $0.32 per common share and unrealized net mark-to-market losses of $0.12 per common share, which are not reflected in operating earnings.

I would also like to highlight that operating earnings for the fourth quarter benefited from an update in Agency RMBS prepayment assumptions, whereby such lower CPR expectation positively impacted interest income by roughly $0.09 per common share. Changes in expectations about prepayment rates, which reflect market fundamentals at the time of assessment, may cause future premium amortization on agency RMBS to vary from quarter-to-quarter.

With respect to our financing at quarter-end, the company had $3 billion of outstanding repurchase borrowings with 17 counterparties. As Michael mentioned, our leverage multiple was 4.1x at December 31, 2013, up slightly from 3.8x at the end of September.

Financing for both Agency and non-Agency RMBS continues to be readily available. The weighted average purchase -- repurchase borrowing costs for the fourth quarter increased to 91 basis points compared to 84 basis points in the third quarter, primarily reflecting our increase in non-Agency RMBS investment and associated repurchase borrowings.

Subsequent to year-end, borrowing rates have come down slightly. As market concerns surrounding new capital regulations have eased and as repo lenders have excess capacity following the deleveraging by mortgage REITs that took place over the past few quarters.

On the topic of AMTG's net interest spread, I would like to comment on some portfolio rebalancing the company undertook within its agency pass-through portfolio in the fourth quarter. With a view towards lowering the company's premium exposure, AMTG sold approximately 21% of its agency 30-year pass-through RMBS with 3.5% and 4% coupons, and redeployed the proceeds back into agency 30-year pass-through RMBS with 4% and 4.5% coupons.

The impact of this rebalancing is reflected in a 59 basis point decrease in AMTG's purchase premium on agency pass through to 7.4% at year-end from 8% at the end of the third quarter.

The yields on the company’s agency pass through RMBS portfolio improved by 30 basis points to 2.82% at year-end from 2.52% at September 30th, of which approximately 17 basis points is attributable to the portfolio rebalancing with the remainder driven by expectations for slower prepayments in the future as well as incremental purchases of agency pass through RMBS at higher yields.

Turning attention to AMTG’s hedging strategy, AMTG had $3 billion of notional interest rate derivative and $400 million of TBA short positions outstanding as of December 31, 2013. Net duration gap, which measures the difference in the interest sensitivity of the company’s assets and liabilities was close to zero as of December 31, 2013, a level with which we currently feel comfortable as we anticipate continued volatility in the fixed income markets. At this point, we will open the line for questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from the line of Steve DeLaney from JMP Securities.

Steve DeLaney - JMP Securities

Good morning everyone and congratulations on a strong quarter to end the year. First just a housekeeping item, Teresa you mentioned a $0.09 benefit from lower premium amortization, I wanted to be clear, was that the total benefit from seeing CPR come down from 6.7% to 4.9% or is that just the part of the benefit that may have been related to a catch-up adjustment? Thanks.

Teresa Covello

That was the catch-up component.

Steve DeLaney - JMP Securities

Okay. That was the catch-up piece.

Teresa Covello

That was the catch-up.

Steve DeLaney - JMP Securities

Okay. So, we should look at that as semi one-time catch-up?

Teresa Covello

Exactly, and then the remainder of it, the impact to the quarter was, call it $0.025.

Steve DeLaney - JMP Securities

Okay, got it. Thank you for that clarity. And Michael, not to let you off the hook here, wanted to ask you about residential whole loan pools, you mentioned a very interesting strategy that I am sure someone will ask about, but you have done -- whole loans are certainly a big part of your background, and you guys did in 2013 a pool, and you bought the loans and you securitized them. It seems we’re seeing a lot more either MPL or RPLs being put out by banks, both large and small, and many more mortgage REITs looking at these pools. I can count a half dozen, I think. Can you talk a little bit about that opportunity? Is that something that you will look -- that Apollo will look to be more involved in this year, and maybe could you talk about the return expectations there relative to legacy RMBS? Thanks.

Michael Commaroto

Yes, that’s fine. We’re happy to talk about that, and you can include us in the REITs look at that product as well. Right now, we’ve probably been a better seller at Apollo globally because we’ve been liquidating our Vantium position. As we see where the market trades in Vantium plus we indicate on pools working through Apollo. To us, the market still feels pretty aggressively priced with respect to some of these market situations. It feels like and even just broadly speaking, new performers tending to trade around 4ish%, maybe 5% yield unlevered. And then non-performers feels like 8 to 9 -- I am sorry, before leverage as well, so we look at these, we haven’t found the right opportunity to get back in the market, vis-à-vis the pool that we bid and purchased, securitized in the first quarter of last year. If you remember, I think that we ended up in, I’d say the high-single digits unlevered, so the market rallied a lot from when we put that trade on.

But we know that business well, and we continue to look at it. What we are really trying to focus on is beyond just looking towards for bidding comp opportunities, whether it’s in agencies or non-agencies, seasoned RMBS or in whole loan pools is trying to come up with ways to originate credit sensitive assets for our book. And so the first one, we spent a lot of time working on this one opportunity that we signed up at the end of last year with the opportunity around creating bonds for titles or contracts with REIT.

That’s really the first thing we have done on credit sensitive space on an origination basis, and we hope to have one or two other pieces of business that look like that over the course of the next quarter to two quarters.

Steve DeLaney - JMP Securities

Okay. So if I am clear on that. You are looking to be a specialty finance lender to a third party who will actually take the ownership of, say single family rental properties, you are going to be the lender not the equity owner of those houses, is that there I am hearing you correct?

Michael Commaroto

I think the way we really think about it is, what we are going to do is try to partner with origination vehicles, origination companies, and use our balance sheet because we have obviously the capital that we control, and use our capital and their front end for their operations sourcing, originate these types of opportunities. So the first one that we have inked is this type of a relationship with an entity that is going to go out and source homes whether they are REOs or they can obviously be MLS, but in any event, they will purchase properties, and with those properties, and with those properties we will finance their purchase and then as those homes then become sold, they are not going to be rented out for the most part; it will be sold to homeowners who are going to basically take that financing …

Steve DeLaney - JMP Securities

Got it, got it. So you will sort of make a warehouse line and then you hope to convert that to a high yielding first mortgage on to the buyer?

Michael Commaroto

Right, seller financing.

Steve DeLaney - JMP Securities

Seller financing. Okay great. I look forward to hearing more about that and thanks for the comments this morning.

Michael Commaroto

You got it. Thank you, Steve.

Operator

Thank you. And our next question comes from the line of Mike Widner from KBW.

Michael Commaroto

Hi Mike.

Mike Widner - KBW

Good morning guys. I think I have the same questions as Steve, so forgive me but I am going to go on to the same two topics. I just want to make sure that in our models and as I look through the numbers that I have, all the amortization and the catch-up benefit and all that stuff right. So I guess maybe the easiest way to ask is, just do you have a premium amortization number and is there a way you could split that out for the quarter between what was the catch up benefit versus what the ongoing, if you will?

Teresa Covello

Right. I don’t have the numbers, I mean we broke it out by per share amount, but what I will tell you is that in terms of premium amortization on the portfolio for Q3, we had $11.2 million of premium amortization, and this quarter it was $7.5 million. So in total, we were down for the quarter by around $3.7 million, so a portion of that was the catch up, so kind of you can back into it based on the average number of shares with the numbers that I gave you.

Mike Widner - KBW

Yes. Okay and when you give those numbers, is that -- that’s the premium amortization just for the agency piece or we are doing net of all the other stuff there?

Teresa Covello

That’s correct. When we look at our non-agency discount accretion, we really benefited there as well, primarily because we grew that portfolio. In Q3, we had net discount accretion of $11.3 million on the non-agency book, and for Q4 that number was $13.5 million. So again, we saw a benefit there because we grew that portfolio.

Mike Widner - KBW

And so, yes I was going to ask that. Let me finish on the agency piece first. If I go to the first table you guys provided in the press release, and I just pick one number for the overall 30-year portfolio, you’ve got a weighted average yield of 2.82% you show. Is that including any of the catch up or is that kind of what we should expect if prepays stayed the same blah, blah, blah, that sort of a run rate number?

Teresa Covello

That number does not include the catch up, because that’s a point in time number, so that looks as our portfolio at 12/31 and rolls it forward based on our expectation.

Mike Widner - KBW

So, all else equal, we can kind of figure on that which is up 30-basis points Q-over-Q, and that’s the other benefit you were talking about?

Teresa Covello

On the rebalancing, yes, the 30 basis points from that, right.

Mike Widner - KBW

Great. And so I guess then going back to the non-agency piece, the discount accretion was higher. I guess I was trying to figure out as we’re going through the numbers, the portfolio was bigger, but also the prepays were slower. So, I don’t know, I guess I’m trying to figure out, I mean what should we -- I mean I guess maybe the easy way to ask it is the yield there that you’re indicating, again, you have kind of 6.73% on that same table for the non-agency RMBS. I mean given what you are seeing, given the composition of new portfolio, I mean do you think that’s a good number?

Teresa Covello

For each quarter, we’ll look at the portfolio, and on a bond-by-bond basis, we run our cash flow projections, based on our views on the housing market, on the spot rate loss severities. So, it’s really a bottoms-up approach and we look at it every single quarter. So the number that you see here in the table one, that is the last time that we looked at it, which is for December 31, so that would be our current expectations as we go forward.

Mike Widner - KBW

Yes, okay that makes sense to me. I guess the other question I’ll ask, I’ll leave the other piece of Steve’s question alone for now. The other question, I guess I’ll ask is just very broadly speaking, it was a rough year and you guys did a lot of rebalancing and adjustments sort of mid-year. And if I just contrast the last 2 -- Q4 against Q3, I mean the core earnings number was basically 36 and then $0.61, so obviously a big difference. Both of those numbers are kind of within the ROE range of peers, and obviously it just depends on how much risk you want to take and leverage and how much you want to hedge out risk. And I guess what I’m sort of wrestling with a little bit here is $0.41 -- or a $0.40 dividend seems to align with a much more conservative stance than say $0.61 earnings. And I know there was some -- again $0.09 benefit was, I guess the $0.09 benefit was obviously in the $0.61 core number that at least it would appear to be. But I guess I’m just struggling with, it’s a huge change Q-over-Q notwithstanding the $0.09 difference, and I’m just kind of trying to put my finger on the portfolio and the amount of sort of risk you guys are comfortable taking on and 15% plus kind of ROEs, but no interest rate risk and sort of conservative, which is the tone you guys sort of struck last quarter, seems like a bit of a contrast. So I guess I’m just trying to fine-tune our expectations on what you guys think the real earnings power of the portfolio is, again, it’s obviously going to be dependent on your risk appetite.

Michael Commaroto

Hey Michael, let me start with kind of the broad question in terms of what we’re trying to do in the portfolio, and I think in late second quarter and then early third quarter, we repositioned the book pretty aggressively out of what we perceived to be rate risk and into more what we considered to be credit risk and we did that by moving out of fixed rate agencies and then with a view towards redeploying that cash into non-agency, primarily sub-prime floaters. So we did that throughout really July, August, and September. And I think what we saw probably in our third quarter numbers was a fair amount of cash drag as we had moved a pretty good amount in broad terms without having the numbers in front of me, probably on the order of $2 billion or more in terms of asset base out of agencies and then taking the cash and then paying down some leverage and redeploying that money, and that took time to do that.

And then on a go forward basis, I think we’ve changed our risk, I think our risk appetite to a large degree stays the same, but in terms of the risk that we’re taking now, I believe we are much more focused on taking credit risk as opposed to pure rate risk and spread risk around fixed rate 30-year mortgages. So we’ve changed some of the risks that we’re taking and that’s been reflected on more of a run rate basis in the fourth quarter numbers.

And as we answered Steve’s question, we hope to continue to do more investing in the credit sensitive space and whether it’s by finding pools of whole loans that we want to buy similar to what we did earlier this year doing that or originating credit-sensitive opportunities like the one that we talked about earlier. And then how this then flows through the dividend, it’s rather than being a quarter-by-quarter analysis, it’s more holistic, and Teresa just kind of explained to you kind of where we’re at.

Teresa Covello

So, the only thing I would add about in terms of risk, yes, we’ve shifted our risk a little bit from interest rate to credit, but in our view on interest rate risk what we’ve done with the portfolio is our view was towards reducing the interest rate risk. Again, at 12/31 we were still at basically a net duration gap of zero. So we don’t see that we increased our interest rate sensitivity, we think that we, if anything, reduced it.

In addition, as Michael mentioned, we did have a bit of a cash drag in Q3 as we weren’t fully invested. And then to your question on in terms of what expectations about a dividend run rate, obviously we can’t give guidance on that.

Operating earnings is definitely one of the key data points that the Board looks at, but there are other data points. And when we distribute, we have to also look at where we are from a re-taxable income perspective. If you looked at our release that we issued at the end of January that broke out the character of our dividend to 2013, you will see that $0.23 of the $0.40 Q4 dividend was included for 2013, so what that means is that the $0.17 is pushed into 2014.

So basically we are starting the year being over distributed by $0.17, so that’s yet another factor. And there are others as well, but definitely operating earnings is one of the data points that the Board considers, but it’s something that is done very real time each quarter and really from a year-to-date perspective.

Mike Widner - KBW

Okay. I mean that makes sense to me. And so I certainly appreciate the shift from interest rate risk into credit risk, and it may not necessarily be – it is different, not necessarily better or worse depends on your rate outlook and your housing outlook, but I understand that. I mean obviously what I am getting to was the expectation for both for dividends and then for ROEs and I guess going back to the other question about your new initiatives, where do you see as sort of a leveraged ROE whether you want to give a pre-expense or post-expense either way is fine, but we don’t see a lot of others that are out there doing that, so it’s hard to gauge what the – so that’s why I am curious what your expectations are for sort of ROEs and then how big can it get, how fast?

Michael Commaroto

Yes, I think it’s really preliminary to give any type of guidance on that. I mean, obviously we are targeting in our non-agency side of the business, I would say, low-double digit or high-single digit levered ROEs. So I’d like to think this business can be competitive with that and I think with leverage probably higher. So in other words I would say we’re probably targeting high-single digit on an unlevered basis. And it’s a function of how much leverage we can apply to this and we’ve really had some discussions with some leverage providers and we’re trying to figure out what the best way is to apply leverage to a product like this.

But the returns should be consistent with where we are in our seasoned RMBS non-Agency yield and with some type of I would say premium on top of that just because of the liquidity attached to it. And in terms of the scale, again still very early to give any guidance on that I think I would rather wait another quarter to get a sense of how the business rolls out.

Mike Widner - KBW

Sounds good, I appreciate all the clarity and congrats on some solid numbers.

Michael Commaroto

Thank you very much.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Jason Stewart from Compass Point.

Jason Stewart - Compass Point

Hi, thank you. Conceptually, could you give us some color about how you are thinking about and operating the derivative portfolio into the quarter? Maybe is it something that you are shifting exposure around or is that a period-to-period number?

Michael Commaroto

I think it’s more a period-to-period number. I mean, it’s always been kind of a small slice of the equity in our book, it’s been probably more opportunistic than not. The inverse IO position is, I view it is kind of little bit of a kicker to our returns in terms of just pure rates, and then with respect to the IO position, a small slice of that is kind of an overlay of the hedge across our path to exposure.

Jason Stewart - Compass Point

And when we look at that swap table that you gave in the swaption table, is this fair to say that’s the average exposure or pretty close to it or does that average shift materially?

Teresa Covello

We, from time-to-time, rebalance. Obviously, you know that we use both swaps and swaption, so you will notice that our swaps were down from Q3 to Q4 and that our swaptions were up, and it wasn't a dollar for dollar offset, but that's something that we really use as a tool to manage our interest rate risk. So, that's something that definitely is looked at often and can be rebalanced as often as needed.

Jason Stewart - Compass Point

Okay. And then since everybody is going to try to get to a book value per share estimate today based on the portfolio, could you comment on any major portfolio changes that you contemplated making or made so far in 2014?

Michael Commaroto

I think in terms of changes we made, I think it's simple to just think about where the market is today versus where it was at year end and where it was in the third quarter. And my sense of it is, I think the non-agency market kind of broadly is probably slightly ahead of where it was at 930 and obviously the agency market is generally where it was, maybe a tad behind kind of the 930.

So, I think that gives you a some rough sense of where us and our peer group might be. And in terms of where we are, in terms of portfolio moves, we don't really want to talk a lot intra-quarter about what we have done to the book. So I think if you just think about where the market is going back to, I can give you a sense of where the book value could be .

Jason Stewart - Compass Point

But to take your comfort level with year end, your duration gap today, I mean that's really fair, you're still comfortable with that position today, it sounds like?

Michael Commaroto

Yes, I think that we just believe a zero duration gap is a prudent way around the business for our shareholders. It just feels like there seems to be a lot of noise around rates in general, and I think given what we saw last year, it's just more prudent to keep the book closer to a zero duration gap than anything else at this point.

Jason Stewart - Compass Point

Got it. And then one last one, and then I’ll get out. I don’t know if I missed anything, new thoughts on share repurchase program, it didn’t look like there was any activity in 4Q perhaps there was activity in 1Q ‘14 or any thoughts or updates there would be great?

Michael Commaroto

No. We continue to look at it as an opportunity to change the capital structure of the business. I think given the new businesses that we’re getting into and liquidity profile of some of those assets and the amount of leverage that may or may not be available for those assets, we are trying to keep as much powder dry with respect to capital. So I think that probably leaves us with a cap on how quickly we want to try and repurchase shares. So we continue to look at that, but we also look at our capital needs going forward with some of the new business initiatives. We are trying to really keep the powder dry with respect to those asset.

Jason Stewart - Compass Point

Thank you.

Operator

Thank you. And that concludes our question-and-answer session for today. I’d like to turn the conference back to Michael Commaroto for any concluding remarks.

Michael Commaroto

I’d like to thank everybody for their support and their attendance on the call today. Thank you very much.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may now disconnect. Everyone, have a good day.

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