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American Capital Mortgage Investment Corp. (NASDAQ:MTGE)

Q1 2014 Earnings Conference Call

May 01, 2014 11:00 AM ET

Executives

Hannah Rutman – Investor Relations

Gary D. Kain – President and Chief Investment Officer

Aaron Pas – Senior Vice President, Non-Agency Portfolio Management

Christopher J. Kuehl – Senior Vice President, Agency Portfolio Investments

Peter J. Federico – Senior Vice President, Chief Risk Officer

Analysts

Douglas Harter – Credit Suisse

Trevor Cranston – JMP Securities

Joel Houck – Wells Fargo Securities

Jason Stewart – Compass Point Research & Trading LLC

Operator

Good morning and welcome to the American Capital Mortgage First Quarter 2014 Shareholder Call. All participants will be in listen-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 Hannah Rutman in Investor Relations. Please go ahead.

Hannah Rutman

Thank you, Andrew, and thank you all for joining American Capital Mortgage Investment Corp.’s First Quarter 2014 Earnings Call. Before we begin, I’d like to review the Safe Harbor statements.

This conference call and corresponding slide presentation contains statements that, to the extent they are not repetitions of historical facts, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results may differ materially from those forecast due to the impact of many factors beyond the control of MTGE.

All forward-looking statements included in this presentation are made only as of the date of this presentation, and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in our periodic reports filed with the SEC. Copies of these reports are available on the SEC’s website. We disclaim any obligation to update our forward-looking statements unless required by law.

To view a webcast of this presentation, access our website, mtge.com, and click on the Earnings Presentation link in the upper right corner. An archive of this presentation will be available on our website, and a telephone recording of this call can be accessed through May 15 by dialing 877-344-7529, using the conference ID 10044282.

Participating on today’s call are, Malon Wilkus, Chairman and Chief Executive Officer; Sam Flax, Director, Executive Vice President and Secretary; John Erickson, Director, Chief Financial Officer and Executive Vice President; Gary Kain, President and Chief Investment Officer; Aaron Pas, Senior Vice President, Portfolio Management; Peter Federico, Senior Vice President and Chief Risk Officer; Chris Kuehl, Senior Vice President of Agency Mortgage Investments; and Don Holley, Vice President and Controller.

With that, I’ll turn the call over to Gary Kain.

Gary D. Kain

Thanks, Hannah, and thanks to all of you for joining us on MTGE’s first quarter earnings call.

We are pleased with MTGE’s results during Q1 as we have begun to see some stability return to the fixed income markets. During the quarter, treasury and swap rates both flattened with longer-term yields declining and short-term rates generally higher as the market began to anticipate an earlier start to the Fed tightening cycle.

Credit sensitive bonds remained very well did with the exception of some areas within emerging markets. As such, non-agency MBS and GSE credit risk sharing securities also tightened and continue to enjoy a strong technical support. Agency mortgage performance was mixed with 15 years ARMs and higher coupon 30 year fixed rate mortgages performing well relative to hedges, while lower coupon 30 years were a little weaker.

Against this backdrop, MTGE was able to produce a 4.5% economic return or 18% on an annualized basis through the combination of our $0.65 dividend and the $0.31 per share increase in book value. Interestingly, both the agency and non-agency portfolios produced similar total returns in Q1.

We were also able to settle our first MSR purchases following our purchase of RCS. MSR transactions tend to require a high level of upfront analysis and due diligence. As such, we expect our acquisition of MSR to be measured over the remainder of the year as we work to identify MSR opportunities that are appropriately priced and importantly have little exposure to adverse pre-payment behavior or counterparty issues.

As I mentioned last quarter, we are very bullish about the long-term potential of MSR investments and remained focused on positioning the company to take full advantage of these opportunities overtime.

Now let’s turn to slide three, and I’ll quickly review some high level results for the quarter. GAAP income totaled $0.95 per share. Net spread income was $0.62 per share inclusive of a $0.04 loss on dollar roll income and excluding $0.03 of catch-up amortization. Taxable income came in at $0.61 per share for the quarter. Undistributed taxable income decreased to $0.73 per share as of March 31. Our book value per share increased to $21.78 per share at the end of Q1. And importantly, both agency and non-agency MBS have performed very well in April providing a solid tailwind at this point as we enter the second quarter.

Now turning to slide four, you can see that our portfolio totaled $6.7 billion as of March 31, and it was comprised of $5 billion in agency mortgage securities, $700 million in net long TBAs and around $1 billion in non-agencies. We also owned approximately $41 million in agency focused REIT stocks at the end of the quarter. And through the combination of dividends received and realized and unrealized gains, these holdings produced a $6.5 million total return in the first quarter.

Our at-risk leverage increased at quarter end to 5.8 times from 5.1 times at the end of December. And as I mentioned, we also invested in and settled our first MSR transaction during the quarter with a market value of $23 million, and additional $25 million was settled at the beginning of April.

If we turn to slide five, we can see how our capital was deployed at the end of Q1. The bottom line is there was a very little change in our capital allocation between the various business lines in the quarter. At the end of Q1, approximately 64% of our capital was dedicated toward agency MBS, 32% to non-agencies and the remaining 4% to RCS and MSR.

At this point, I will turn the call over to Aaron Pas to discuss our non-agency portfolio.

Aaron Pas

Thank you, Gary. Overall, the environment for levered credit investments continues to be very good, which is positive for existing holdings, but a challenge in terms of finding attractive growth opportunities.

On the fundamental side, we continue to believe housing and credit fundamentals remain intact. However, some housing metrics are beginning to show signs of moderation. Furthermore, mortgage credit availability still remains very tight in all cash transactions comprised just over 30% of existing home sales.

As Gary mentioned, the technical backdrop for non-agency MBS is quite good. As an asset class, the non-agency market is now under $800 billion UTB representing a decline of roughly 15% year-over-year. At current market prices, this translates to a market value of around $600 billion.

In addition to the shrinking supply being supportive of credit spreads, improving loan to value ratios, falling delinquency rates and reduced sensitivity to servicer behavior should also lead to a stabilization in cash flow projections and in turn tighter credit spreads in the future. It is worth nothing that we believe that the composition of our portfolio specifically are overweight to the Alt-A sector should benefit from this stabilization.

The combination of these two factors led to another strong quarter of performance for our non-agency assets both in absolute terms and relative to other risk assets including investment grade and high yield corporates. The resiliency of legacy non-agencies was even more apparent in late January and early February when the weakness in the emerging markets failed to spillover the non-agency MBS. In total, non-agency spreads tightened 25 basis points to 50 basis points.

Overall, our non-agency portfolio was relatively unchanged in size, in composition over the quarter. One change that is worth noting however, is the increase in our exposure to GSE credit risk transfer securities which we have included in our prime exposure category.

On the new production side of the equation, issuance in the jumbo market continues to remain muted and we expect this to persist even though AAA price spreads relatively to TBA have tightened recently. It is interesting that jumbo origination volumes remain muted despite the availability of rates that are generally 12 basis points to 25 basis points below the rates offered to high quality confirming borrowers.

In light of this, we expect the majority of new credit risk in the near term will come to the market in the form of credit risk transfer issuance from the GSEs. So far in 2014, Freddie Mac and Fannie Mae have combined a sell credit risk on approximately $75 billion of mortgages. Consistent with improving liquidity, greater investor acceptance and demand for credit and housing sensitive assets, spreads on these transactions are paying significantly over the last several months.

Additionally, over the last six months, financing of these securities has improved with haircuts and repo rates both declining. At this point, we believe levered credit risk transfer securities offer incremental value over levered non-agency MBS. We have increased our investments in the more subordinate securities.

As of the end of April, we owned approximately $50 million GSE credit security. While we believe these securities will provide better returns in the base case, given the embedded leverage and downside risk, it is critical that it’d be sized appropriately within the portfolio.

With that, I’ll turn the call over to Chris Kuehl who will discuss the agency portfolio.

Christopher J. Kuehl

Thanks, Aaron. Agency MBS performance during the quarter was mixed and largely a function of what part of the curve your hedges were concentrated in versus the long end, mortgages lied in the fair amount. However versus the five year part of the curve, they performed quite well.

On slide seven, you can see that our agency investment portfolio increased by approximately $800 million during the quarter to $5.7 billion with the growth coming from both 30 year and 15 year MBS. The increase in our MBS position was driven by our view that performance would improve based on strong supply demand technicals, lower volatility and attractive core financing. The other notable change in the composition of our agency investment portfolio this quarter was the increase in our TBA role position from a net short of $800 million as of year-end to a net long of approximately $700 million as of 3/31.

Dollar roll financing improved following the taper announcement in December and throughout the first quarter. And while there are tradeoffs in rolling versus carrying specified polls, the benefits of owning polls are lower now for several reasons. With each additional month the Fed purchases, the TBA deliverable improves as the Fed absorbs more and more of the cheapest to deliver float. Secondly, refinancing activity is extremely low and is expected to remain muted and therefore prepayment differences on different types of MBS are not a major factor.

To this point, if we turn to slide eight, you can see that the refi-index released yesterday registered its lowest ratings since 2008. While these extremely low levels of refinancing activity have obvious implications for pre-payment rates, it also suggest that gross mortgage issuance may continue to surprise to the downside, further supporting the strong technical backdrop for mortgage performance over the near term.

The last point I’d like to make is on the graph on the right, which shows historical and projected gross origination less Fed and GSE purchases. 2014 is expected to have the lowest amount of mortgage supply net of projected Fed and GSE purchases since 2009. The blue dots in the graph show the annual average of the daily option adjusted spreads on new production 30-year MBS over the same time period. While this is only one of many ways to assess relative value and the average annual number smoothed out significant intra period volatility, it’s hard to look at these numbers and conclude that QE tapering is not priced in. If anything that series suggest that mortgages have widened too much as of the end of the first quarter.

With that, I’ll turn the call over to Peter to discuss funding and risk management.

Peter J. Federico

Thanks, Chris. I’ll begin with our financing summary on slide nine. Our average repo cost increased slightly to 58 basis points during the quarter from 56 basis points last quarter. The slight increase in cost was driven by a shift in our funding composition for the greater share of non-agency repo.

We continue to see very attractive funding opportunities for both agency and non-agency collateral. In the agency market, funding rates fell about 3 basis points during the quarter and in the non-agency market rates fell slightly and our funding capacity increased.

On slide 10, we provide a summary of our hedge portfolio. In total, the notional balance of our hedge portfolio increased slightly to $5.3 billion and $4.9 billion last quarter. We also continue to shift the composition of our hedge portfolio for the greater share of rate base hedges and a smaller share of option based hedges. Consistent with this shift, the total notional balance of our swaption portfolio fell to $425 million from $2.1 billion last quarter.

With respect to rate based hedges, we added both pay-fixed swaps and short treasury positions during the quarter. The growth in our swap portfolio included $700 million of forward-starting pay-fixed swaps bringing our total position in forward-starting swaps to about half of our overall swap portfolio. We increased our use of forward-starting swaps over the last several quarters because we believe these swaps will be a very effective hedge for our assets as the Fed transitioned its stance on monetary policy from its current position of ultra accommodation to eventually monetary tightening.

Today, the Fed’s relied heavily on forward guidance to control the very front end of the yield curve. Intermediate and longer-term rates however are harder to control and were subject to changing expectations around economic growth and inflation. Against this backdrop, forward-starting swaps can be a very effective hedge because they allow you to precisely tailor your interest rate protection to specific parts of the yield curve.

To better illustrate this point, consider an example that compares a regular seven year swap to a forward-starting five year swap. When you enter into a regular seven year swap, you’re essentially buying protection on all swap rates from one month to seven years. Given the Fed’s current monetary policy stance, however, the movement in various rates along the yield curve is likely to be very different.

Specifically, we believe there is very little risk that very short-term rates move significantly. As such by entering into a regular starting swap, you are essentially buying protection on rates over the next 12 months to 24 months that you don’t necessarily need.

In comparison, by entering into a five year swap that starts in two years, you can concentrate your protection in year’s two through seven rather than spreading it out over the entire seven year period. Lastly, on slide 11, we provide a summary of our duration gap and duration gap sensitivity. At quarter end, our duration gap was 1.3 years, slightly lower than the 1.6 years reported the prior quarter.

With that, I will turn the call back over to Gary.

Gary D. Kain

Thanks, Peter. And at this point, I’d like to open up the call to questions.

Question-and-Answer Session

Operator

We will now begin the question and answer session. (Operator Instructions) The first question comes from Douglas Harter of Credit Suisse. Please go ahead.

Douglas Harter – Credit Suisse

Thanks. Can you – you did mentioned that you made one MSR investment, but can you talk about the process to getting that business to breakeven or eventually generating positive return on the capital allocated there?

Gary D. Kain

Sure. Look - as first thing that’s important to keep in mind is that the first MSR approaches actually occurred relatively late the one that’s – the first one that settled during the quarter occurred relatively late in the quarter. So we can get the benefit of that for very long. The next component of that or the one we mentioned the other we’ll call it half settled in early April. So you know, you are looking at kind of the expense structure for kind of the whole period and to your point, you know we are starting to kind of add the assets in.

Look, the bottom-line is again and I want to be very clear on this. This is a strategic investment for us that we feel very strongly about over the long run and the opportunities will be good. It will – it will take us – a few quarters under kind of our projected purchases to bring our cost and revenues in line and we are totally comfortable with that and we think that’s the right investment kind of mindset.

The other thing is that we want to be diligent about these investments. We could clearly wave things in that will get that number up. But we – we want to grow it in a measured way. So the short answer is look for – look for those expenses on a quarterly basis to be dropping and we certainly expect that – by the end of the year, those will be – those have good chance of being flipped.

Douglas Harter – Credit Suisse

And then just as you’ve said, it’s a strategic investment, how are you thinking about that loss when you – when the board sets the dividend?

Gary D. Kain

Look there are so many things that go into the dividend policy and dividend decisions. I would say that we are – we will give it consideration from that perspective and from our mindset one off or very short-term types of expenses that aren’t likely to be repeated are not something that generally dictates changes to the dividend.

Douglas Harter – Credit Suisse

Great. Thank you, Gary.

Gary D. Kain

Thanks.

Operator

The next question comes from Trevor Cranston of JMP Securities. Please go ahead.

Trevor Cranston – JMP Securities

Hi. Thanks. Another one on the MSRs, in the context of MBS durations having extended and the reduction in the size of your swaption portfolio, can you talk a little bit about how much negative duration you see MSRs having generically today and also how much convexity hedging you think ought have to do with that as the MSRs become larger part of that portfolio?

Gary D. Kain

Sure. So look, first off, I think your point is very well taken and that when you – the negative duration that IO or MSR kind of typically has is reduced to the extent that that IO or to the extent that those coupons are out of the money and the prepayment expectations are relatively slow to being with. So I think we are very practical about the fact that we don’t want to overstate in this environment the code hedging benefits of MSR.

On the other hand, it does still provide some duration benefit, it does provide some extension benefit of prepayments turnout to be slower than you expected in a rising rate environment, there is an offset there. But to your point we are going to overly rely on the negative duration of IO in this environment relative to the portfolio. I’ll let Peter kind of add something to that.

Peter J. Federico

Yeah, well – yeah, obviously the price at which we buy them will matter a lot and obviously prices have moved. So from the low multiples we saw a year ago to the current multiples, there is not quite as much of price appreciation given the rate movement and the change of prices that we’ve already seen in MSR.

So the hedging benefit is not as big as it was a year ago, but we will still using them, they will still provide some upright protection, as Gary mentioned, and we’ll still need some form of options in our portfolio more likely, more out of the money options coupled with the MSRs as we build that portfolio over time.

Trevor Cranston – JMP Securities

Got it. Thanks. And then just popping to the credit side of the portfolio, you mentioned that GSE restrained yields had increased a little bit as a percentage of the portfolio this quarter. Is that still where you guys are kind of seeing the best opportunity in the non-agency space right now? Are spreads tightening up there that – that area is quite as attractive, some of the legacy securities anymore?

Gary D. Kain

So that’s the difference between those kind of levered ROEs has started to compress as spreads have tightened more on the credit risk transfer securities as of late, but they still offer a little bit of additional value in the base case. But to the point I made in the prepared remarks, you have to be cognizant about how much of those types of securities you have in the portfolio given may be you have a different kind of risk profile in a downside scenario.

Trevor Cranston – JMP Securities

Okay. Appreciate the comment. Thank you.

Operator

(Operator Instructions) The next question comes from Joel Houck of Wells Fargo. Please go ahead.

Joel Houck – Wells Fargo Securities

Hi, good morning. First question is, you – in April you had about 40% your repo roll off, just wondering what – where that kind of roughly reprice that because that’s typically we don’t see that big of a percentage roll off in a single month?

Gary D. Kain

Yeah, hi, Joel. The overall agency repo rates we are seeing down is about 5 basis points – 3 basis points to 5 basis points from last quarter. We are seeing a little bit of improvement in the non-agency side both in terms of rates and hair cutting and capacity not quite as much. So we continue to see particularly on the agency side repo rates coming down slightly.

Joel Houck – Wells Fargo Securities

Okay. And that two being given the 71 base for interest rate that looks like it is roughly half agency, half non-agencies, is that the right way to think about it?

Gary D. Kain

In last quarter?

Joel Houck – Wells Fargo Securities

Well I’m just turning to slide 9, you get $2 billion of repo outstanding to 71 basis point rate that will roll off?

Gary D. Kain

Yeah, that’s right.

Joel Houck – Wells Fargo Securities

Okay, good. Alright, and then kind of switching gears, we are trying obviously with the servicing building up, its – we’re going to have to start modeling both the revenue and expense component, is there any like guidance I don’t know if you guys put out a UPB number, I had to jump on the call little late, but the servicing and other operating expenses of $14 million is a significant component in our total OpEx, so any guidance you guys can give us to help us model this going forward would be helpful?

Aaron Pas

Yeah, I’ll start and then Gary might want to chime in about sort of the longer term outlook. But as you point out on slide 17, we have both components broken out, the revenue side which is about $9.2 million and then the expense side of $14 million. So that leaves us about $4.8 million loss this last quarter. I would say about $500 million of that you could take – treat as one time.

So we expected naturally to come down, but then of course as Gary mentioned, we expect that remaining deficit to start to compress as the MSRs that we’ve already purchased start to show up in terms of the full benefit and then of course the growth overtime that we will have in that portfolio and Gary can talk about that outlook.

Gary D. Kain

Right I think – look for us to, we’re certainly going to look at both sides of that numbers or the net and we’ll work on and be concentrating on expenses as well as obviously the revenue piece. And so – look we’re not – it’s not going to close in a quarter, but it is absolutely in our minds going, we absolutely wanted to close over the course of let’s say the next year.

Joel Houck – Wells Fargo Securities

Okay. Just declare, that was $5 million in one-time expenses?

Gary D. Kain

Otherwise it would close very quickly.

Joel Houck – Wells Fargo Securities

Right, yes, good point. Yes, so I guess, I mean – I think you guys are well known for running businesses rationale; I don’t think people are concerned about the gap closing. As I am more from – analyst perspective trying to figure out how we – typically what we do is we take a UPB and then you have your – your revenue built-in assumption and then you’re free to make whatever cost assumption, I guess that’s more I was thinking about in asking the question.

Gary D. Kain

Look, we’ll certainly – there will be more information obviously provided in Qs. But looking – going forward, as these numbers become more material, we will certainly look to expand the disclosure.

Joel Houck – Wells Fargo Securities

Okay. Great. Thanks guys.

Operator

And our last question comes from the line of Jason Stewart of Compass Point. Please go ahead.

Jason Stewart – Compass Point Research & Trading LLC

Hi, thanks. One more if I might on the MSRs, just either conceptually or a very high level, could you just give us an idea of what kind of IRR assumptions, if you don’t want to give us the details that you are looking at there? And then also conceptually, you have a choice of either reducing your hedges, reducing your assets or increasing your ROE as you grow MSR as a hedge and just how you are thinking about those two variables would be helpful?

Gary D. Kain

I will comment on kind of current market conditions. I mean generally speaking I expected yields are in the mid to high single digits. But for the conversation that we had earlier, it really depends a lot on the note rate strike of the MSR, the product type and its duration.

Aaron Pas

And then look a picture kind of going back to the earlier question around the hedging benefits. It’s very dependent on the coupon, the age, the price, there are lot of other factors that go into the market environment, the shape of the yield curve that go into how much negative duration or how much hedging benefit we are willing to assign to the MSR. And so, the bottom line is that we would expect overtime to reduce the fixed component of our hedges, the pay-fixed swaps due to the MSR.

But overtime, not to reduce the option component because, the MSR doesn’t really give you any benefit on the convexity side from a hedging perspective. It actually gives you some more convexity risk. So, what you really will look to see over time is reduced swap hedges and actually, slightly increased swaps and hedges over the long run again.

Jason Stewart – Compass Point Research & Trading LLC

Okay. But not – we did not de-levering the asset side and that’s not part of this equation right now?

Gary D. Kain

No, it is not part of the equation at this point. I mean look in the end, right, you need capital for – you do need capital for incremental purchases of MSR over time and so yes you are going to look at allocating capital. But currently given the sizes we are very comfortable with the way the portfolio is laid out.

Jason Stewart – Compass Point Research & Trading LLC

Okay. And then one another strategic question, have you thought about or started looking at any other asset classes, let’s say as NPLs or other loan portfolios?

Gary D. Kain

We have I mean what we are cognizant of is when we go into new business line so to speak or start adding incremental expertise and start to diversify the portfolio, we really are – we put a relatively kind of high bar over – around new products where we don’t – where we see them as very short term opportunities. Whereas, we take a very different approach to things that we feel are – could be important to the long run opportunities.

And so, what I would say there is you know we’re very committed and I think you’ve seen that in our behavior committed to MSR, because we see it as a very good long run fit and a very good long run opportunity for MTGE that will only improve with time. When you got to NPLs as an example, we see that as a very short-term trade and while it could fit in with RCS and we may consider one-off things, there is a higher bar there.

Operator

We have now completed the question-and-answer session. I’d like to turn the call back over to Gary Kain for concluding remarks.

Gary D. Kain

Well, I’d like to thank everyone for their interest in MTGE. And we look forward to talking to you next quarter.

Operator

The conference has now concluded. An archive of this presentation will be available on MTGE’s website and a telephone recording of this call can be accessed through May 15 by dialing 877-344-7529 using the conference ID 10044282, again 10044282. Thank you for joining today’s call. You may now disconnect.

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