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Arlington Asset Investment (NYSE:AI)

Q1 2014 Earnings Call

April 29, 2014 9:00 am ET

Executives

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

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

J. Rock Tonkel - President, Chief Operating Officer and Director

Brian J. Bowers - Chief Investment Officer and Portfolio Manager

Analysts

Trevor Cranston - JMP Securities LLC, Research Division

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

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

Douglas Harter - Crédit Suisse AG, Research Division

Operator

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

Kurt Ross Harrington

Thank you very much. Good morning. This is Kurt Harrington, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations, and any other guidance on present or future periods, constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These forward-looking statements are based on management's beliefs, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the company's Annual Report on Form 10-K for the year ended December 31, 2013, and other documents filed by the company with the SEC from time to time, which are available from the company and from the SEC. And you should read and understand these risks when evaluating any forward-looking statement.

I would now like to turn the call over to Eric Billings for his remarks.

Eric F. Billings

Thank you very much. Good morning, and welcome to the first quarter earnings call for Arlington Asset. I am Eric Billings, Chief Executive Officer of Arlington Asset, and joining on the call today are Rock Tonkel, President, Chief Operating Officer; and Brian Bowers, our Chief Investment Officer.

Yesterday, we reported core operating income per share diluted of $1.18 for the first quarter, which equates to a 20% return on book value available for investment. First quarter performance was driven by continued improvement in private-label MBS credit performance and prices complemented by low CPRs and attractive cash spreads in our agency MBS portfolio. In March, Arlington raised $82 million in common equity, which was accretive to investable book value, and will positively impact future cash earnings while further reducing the company's expense-to-capital ratio, boosting return on equity and efficiently utilizing tax benefits. We expect the March offering to be accretive following full deployment of the capital, but it had no effect on core operating EPS in the first quarter. We expect all of the proceeds from the March offering will be allocated to the company's agency MBS portfolio. Including purchases and pending settlements in mid-May, the company's agency MBS portfolio now equals approximately $2.6 billion in market value, with corresponding hedges of approximately $815 million in 10-year duration swap futures and approximately $1.5 billion of Eurodollar futures, which extend through March 2019. Agency MBS balances may increase during the second quarter, with full deployment of the recent offering.

Following recent purchases, the company has approximately 51% of investable capital directed to the private-label MBS portfolio, and 49% allocated to its hedged agency MBS portfolio. Given current market conditions, as our private-label MBS reach our appreciation targets and we execute sales of private-label MBS, our allocation process will naturally migrate capital to the agency MBS portfolio with a corresponding positive effect on core operating income. For the year-to-date, the company had $16 million of proceeds from the sales of private-label MBS with a current cash yield of 6%, which we migrated into fully-hedged agency MBS which -- with expected current cash yields on the reallocated capital in the mid-teens. Cash expenses, as a percentage of investable capital, should decline by approximately 50 basis points as the result of the offering, and drive a corresponding pickup in cash ROE. As an internally-managed company, there is further opportunity for leverage on fixed costs as we grow. While $50 million of net capital loss carryforwards are expected to expire in 2014, the company has approximately $200 million of remaining net operating loss carryforwards and other deferred unrealized losses that are available for use in future periods. At current earnings levels, the company's tax-advantaged C corporation flexibility, 2% cash rate and a qualified C corporation tax treatment on dividends could extend until 2018 and beyond.

The company has chosen to modify non-GAAP core operating income to better reflect the attributes of its business. As a result, the company excludes both the realized and unrealized fluctuations in the gains and losses in the assets and hedges on its hedged agency MBS portfolio when assessing the underlying non-GAAP core operating income of the company. This will result in presenting cash spread income for the company's agency-backed MBS portfolio and non-GAAP core operating income, whereas realized and unrealized gains and losses on assets and hedges for the agency MBS portfolio will continue to be included as components in the changes in book value and in the GAAP net income of the company. Given the outlook for the U.S. economy, the Federal Reserve's tapering of QE3 and normalizing interest rates, we continue to maintain an overall hedge position approximately equal to market value of the company's agency MBS position with the goal of a -- of neutral to slightly negative duration.

During the first quarter, the Eurodollar futures contracts we utilized to hedge our agency MBS portfolio ran consecutively on a quarterly basis, beginning in March 2015 and then extending out to March 2019. On a mark-to-market basis, they had an average notional amount of approximately $1.1 billion with a collateral rate of 2.27% and an equivalent funding cost over the next 5 years of approximately 1.73%. In order to extend the duration of our overall hedge positions to approximately match our MBS asset duration, at quarter end, we had 10-year interest rate swap futures in total notional amount of $625 million with a mark-to-market average cost of 2.87%. While mark-to-market gains or losses can occur over time, to the extent mark-to-market hedge values are lower, then funding costs and agency MBS will be lower for a longer period. With an asset yield of approximately 3.6% and a blended hedge funding cost of approximately 2.15% at quarter end, we continue to believe this structure allows us to earn an attractive spread and protect the value of our portfolio as the economy, monetary policy and markets normalize. In the first quarter, our agency MBS portfolio demonstrated a 3-month portfolio CPR of 5.7% versus CPRs at 6.6% on Fannie Mae Forbes coupon universe. Approximately 64% of our agency MBS portfolio was originated under HARP programs, and our remaining assets consist of either low-loan-balance loans or loans with other prepayment protection features. Access to funding is continuing to improve for the company. Our roster of repo counterparties continues to grow, and available capacity has increased for repo on both agency and private-label MBS.

Moving to the private-label MBS portfolio. On March 31, 2014, that portfolio had a fair value of 72% of face value, total market value of $330 million and repo of $62 million. OCI related to the private-label security was $60 million as of March 31, 2014. The assumptions used to value the portfolio at March 31, 2014 included, on a weighted average basis, a constant default rate of 3.4%, loss severity on liquidated loans of 44%, constant prepayment rate of 11.6%, and a discount rate of 6.5%. Looking forward to a point 2 years from now, we expect approximately 90% of our re-REMIC portfolio to be variable rate in nature and to insulate the portfolio from potential future increases in interest rates.

In our private-label MBS portfolio, we continue to observe reductions in serious delinquencies across the portfolio, as they have declined from approximately 19% to 15% over the past 9 months. Likewise, loss severities have declined from 45.9% to 33% over the last 9 months. The value creation from that process is being reflected over time in the deleveraging of our securities, higher expected cash flows, increased terminal values, and ultimately, higher prices. The expected overall terminal par value of our re-REMIC mezzanine securities is substantially above the current price of 72, and our view is that the appreciation will occur within approximately 1.5 year period, resulting in total annual returns on our private-label securities in the teens from their current price level. While we may not realize all of the terminal value on every private label bond because yields at that point will have declined below our return threshold, we would expect to receive higher risk-adjusted returns on competing investments. Another way to think about this dynamic would be to assume, for illustration purposes, that the $268 million of capital currently allocated to our private-label MBS portfolio were reallocated to agency MBS at approximately a 16% return on equity on a hedge basis. Because today, we recognize only the cash -- current cash yield on earnings -- and earnings from realized gains in our private label MBS portfolio for core operating income, such a change in allocation would produce an increase in current hedge spread income, which would provide additional flexibility to potentially expand the dividend or accumulate capital, given our C corporation structure.

In the meantime, we continue to be optimistic about Arlington's opportunities. The company continues to benefit from its hybrid portfolio structure, earning competitive returns on its hedged agency MBS portfolio, and simultaneously experiencing capital appreciation in its private-label MBS portfolio. The majority of our capital is allocated to floating-rate private-label MBS, with a discount price of 72% of par and a significant per share appreciation potential. Our agency MBS is substantially hedged and our low -- our leverage is low, our liquidity is high and our funding capacity is increasing. Looking forward, cash earnings will benefit from the migration of appreciated private-label MBS to hedged agency MBS and a reduced expense-to-capital ratio. The investment dynamic of our company and our portfolio have continued to perform consistent with our expectations. At current cash earnings levels, our net operating loss carryforwards will remain available until nearly 2018.

Operator, I would like to now open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Trevor Cranston from JMP Securities.

Trevor Cranston - JMP Securities LLC, Research Division

On the agency portfolio, you guys have traditionally been pretty focused on the 30-year specified pool sector. I was wondering if you could just share your general thoughts on kind of where you think -- what's your outlook for spread bids over the balance of the year, as Fed continues to wind down taper? And also just share your general thoughts on the other sectors of the agency market, if you're looking at those and finding any attractive opportunities in sectors like 15-years or hybrid ARMs.

Eric F. Billings

Well, just generally, we try to be somewhat agnostic on our view of interest rates, as you can see, in our structure, our hedge structure. It seems fairly obvious, having said that the economy is normalizing, and then over the long term course of events, zero Fed funds rate obviously still reflects a crisis circumstance, which is quite clearly past. So it is inevitable that, that part of the rate structure will start to move it up at some time in the future, and probably, the rest of the curve will follow at some level. For us, the key is to enjoy the character of the spread and the yield curve as we are structured today, and to have the portfolio be in a place where, when and if or as the day comes that the yield curve eventually flattens and even potentially inverts, which is a normal course of cyclical events, which at some day in the future will occur, we have the flexibility on the portfolio to adjust accordingly, and to maintain our structure without significant damage or damage to the capital of the company. And that is the nature of how we run the business. So it leaves us in a position, where we don't have to be guessing rates based all on spread. We feel it's the most attractive for sure [indiscernible].

J. Rock Tonkel

I think we -- the key for us, as Eric said, is that we're going to structure and have an overall financial position that allows us to sustain that structure through movements in the market. And so to the extent we see movements in basis or otherwise, then if they're negative, we'll get the benefit of that in the future. And if they're positive, it means that the margin lower of returns -- new returns maybe lower, and we'll react to that with the appropriate adjustment. So I feel like as long as we can -- as long as we're able to maintain that structure, then we'll generate the economic benefit from that portfolio that we see -- that we expect. Looking across the spectrum, I think we've seen points over the last quarter, where the 15s, and those in particular, started to look pretty interesting. They got a little cheaper, and then they got a little more expensive, and so we feel like we're in the right place in the 30-year asset, and that's how we look at it. Brain, do you have anything you want to add?

Brian J. Bowers

No, the only thing I'd add is, yes, we continue to look at all the various sectors and all the opportunities, which includes 15-year, 20-year or hybrid. But we're continuing to find the most attractive area to be the 30-year product, in particular, where we can. Types of product there we like is the prepayment protection, in particular, to keep CPRs relatively low. So we find that -- we continue to find that sector to be the most attractive to hedge and the most attractive to maintain a constant spread or NIM on a relative basis, on a go forward basis there.

Operator

Our next question comes from Jason Stewart from Compass Point.

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

Have you just seen any material change in pay-ups on specified pools year-to-date?

Eric F. Billings

No.

J. Rock Tonkel

Not really material, maybe a bit of a pickup there, but not a huge change, Jason.

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

And I guess, given your rate outlook, that might not be surprising. But it does seem like there's free optionality in those bonds, and I'm just -- I'm wondering if it surprises you that there's nobody paying attention to that sector.

Brian J. Bowers

Jason, yes, we would agree with your comment about the free optionality. And look, right now, the market participants haven't been recognizing that particular benefit. Maybe if rates continue to go lower or they perceive that rates will stay lower, that the pay-ups will then begin to adjust on a relative basis. So at this point, we would agree with you, we like the attractiveness of that sector and we like the attractiveness of the fact that the pay-ups are still relatively cheap on an overall basis.

J. Rock Tonkel

One comment there, Jason. You can sort of observe from what you've heard in the script here that we've shifted a little bit from the HARP to the other types of spec pools. And there may be -- that could be more of the case going forward is the -- to the extent that supply shifts on the HARP side. So these are things that we're mindful of. We're flexible. We can adapt to it very easily. But that -- depending on the flow of HARP product, we may see that number shift around a little bit. It doesn't really affect anything much. We still get the -- we're seeing the prepaid benefit pretty much across the board. So whether it's a HARP or low loan balance or otherwise, we'll pick our spots and be satisfied with that.

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

Yes, it just seems -- I mean, when you go back and look at our data at least, pay-ups with some points were over 100 ticks, and the rate view may not be lower from a consensus standpoint, but there seems to be some embedded value or optionality there that's not being reflected with pay-ups flat. So I was just -- I appreciate your comments on that, and that's perfect. And then on the non-agency portfolio, the decline in CPR, was that mostly voluntary or involuntary?

J. Rock Tonkel

I think it's more of the credit side of it, Jason. It's -- we just continue to see improvement in tier rates and relative to new delinquencies. So I just think it's -- improvement there is false [ph]. I don't think they're changed a lot.

Eric F. Billings

No, really haven't.

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

Okay. So no real impact from the change in debt forgiveness on short sales? I mean that wasn't a big driver of activity in the quarter?

J. Rock Tonkel

I don't have it at that level of detail off the top of my head, Jason. I just think the dynamic is there, and that's a good thing, right, because as the -- to our surprise, to some degree, to our surprise, we still have enhancement left in some of these bonds that we wouldn't have otherwise expected to be here at this late date. So to the extent that you still have a little enhancement, then you're still getting -- and you're still getting voluntaries at really high levels. That's a real positive to the bond. When your invols are going down, you're simply pushing off into the future potential bond loss, and at the same time, collecting that difference between your basis and par. So it's a pretty positive dynamic across the board.

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

All right. One last one, and I'll jump out. The $16 million of non-agency sold, I didn't catch if that was a face number or market value, and is that the case we should expect going forward? Or is that just going to vary depending on price and opportunity to redeploy the capital?

J. Rock Tonkel

Completely dependent on price and opportunity on both sides, right, whether it's on the sell side, if it hits our price targets and falls below our threshold returns; and on the other hand, if the agency opportunity is -- provides a higher risk-adjusted return, then the capital moves. So it's completely a product of market conditions at a given point in time. That $16 million was the proceeds.

Eric F. Billings

But, I mean, obviously, Jason, it's just going to be market-dependent, and the analogies we've used in the past, which are, to the degree we own these bonds, at a blended base of 72, obviously, is a lot of bonds. So it's an average, and we think the average might be, for instance, 90 or something in that vicinity. So if it's going to take 2 years, well, you can -- let's give or take something in the vicinity of 23%, 24% move plus the coupon, well, if it's 2 years, that's going to get us something in the vicinity of mid-teens, high-to-mid-teens ROE. To the degree that we can come out of those bonds, for instance, in the high 70 to 80, 81 -- one, as they evolve, then that's not all one package, then that changes that dynamic dramatically, and we can redeploy that into the agency spread and it's -- that's how we do it. So the -- you saw $16 million in the last quarter. As we go forward, it's probably entirely reasonable to assume that these -- the pricing is going to continue to move up, continue to appreciate, because that's what it's been doing now very consistently for a long time, and so I don't know that we think it will accelerate, but it's certainly reasonable at some level to expect at least a continuation of that trend. And then obviously, eventually, you'll get -- probably get some kind of a hockey stick move on it. But we'll just wait, let the market give us the opportunity, and take it when we can.

Operator

Our next question comes from David Walrod from Ladenburg.

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

Just a couple of things, not too much more. It sounds like you're close to being fully deployed in the new capital raise. Do you anticipate wrapping it up in the next week or so?

J. Rock Tonkel

Give or take, yes, I mean, by May, settle -- certainly, by regular May, settle.

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

Okay. And now that you're kind of reallocating your focus, any change to your thoughts on leverage in either of the 2 portfolios?

J. Rock Tonkel

Not really. The non-agencies are sitting just, I think, a shade below 0.2, which as you know, sort of been our level there for a long time. And I think the agency -- the new agency capital will go to work at about 8. I think the overall blended on the agency will be a little higher than that because the preexisting portfolio is probably a little bit more highly leveraged than that, but we're totally comfortable with those metrics.

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

Great. I think Eric said that, post April, the capital allocation was 51% in the private label and 49% into the MBS. Where do you envision that settling in?

Eric F. Billings

Well, I mean, it depends on, David, on your timeframe. Eventually, obviously, I think we expect that the non-agencies will trend to 0. If those assets continue to appreciate in price, then by definition, as they get to what we think is their equivalent par value, and would be something that's going to be around maybe a 90 price, then of course, we would only be achieving a coupon, as most of those are adjustable rate, that would be something in the vicinity of 2.5% coupon. With the little bit of leverage we have on it, it's closer to 3%. But obviously, well before then, we will have exited that portfolio and moved into the agency structure, where we're achieving mid-teens, and sometimes a little higher than that return. So you can see that matrix, if that occurs, that those prices continue to appreciate in time, as we said in the script, we would anticipate at this point, within 1.5 years, we would probably have moved out substantially all of those assets and moved them to the agency's portfolio. And it's hard to say, but it's a guesstimate at a 1.5 years, and obviously something that could happen considerably quicker than that if pricing continues to gain momentum, but that's our ballpark estimate right now.

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

Okay, that's helpful. And then, please, just a quick question on the tax charge. What do you think -- what was that about?

Kurt Ross Harrington

Tax charge, sorry, you mean the tax provision?

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

Yes, the tax provision.

Kurt Ross Harrington

For the tax provision, it was at a normalized rate of around 38%. We know most of that is deferred taxes, and the cash taxes were 277 -- $300,000, roughly 2% of the non-capital gain income.

J. Rock Tonkel

That's pretty consistent with historical.

Operator

And at this time, our next question comes from Douglas Harter from Crédit Suisse.

Douglas Harter - Crédit Suisse AG, Research Division

[Audio Gap]

...on some alternative investment opportunities you're seeing, and if anything, is interesting or close to coming to fruition?

Eric F. Billings

I would say that we continue to look at a number of different types of opportunities. I don't think anything is what we would describe as close at all right now. And we are just trying to be very opportunistic about it, and move with a lot of thoughtfulness to the process. And if we see something that on a risk-adjusted basis we felt could exceed the returns we're achieving in either of our portfolios, then again, we would be -- are willing to move some level of capital into that kind of an area. Having said that, in this environment, it is very difficult for other asset types to compete with these returns. So it makes it very difficult to -- for that to happen. But again, we look at everything, and we have many, many years of experience in the financial -- specialty finance world, and so if that comes to pass, it's certainly not something we're unwilling to do.

Operator

Thank you. Mr. Harrington, there are no further questions at this time.

Kurt Ross Harrington

Okay, thank you, everyone.

Brian J. Bowers

Thanks, everybody.

Eric F. Billings

Take care.

Operator

Thank you, ladies and gentlemen. This conclude today's conference. You may now disconnect.

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