MFA Financial, Inc. (NYSE:MFA)
Morgan Stanley Financials Conference
June 10, 2014 10:20 AM ET
Bill Gorin - CEO
Craig Knutson - President and COO
Cheryl Pate - Morgan Stanley
Cheryl Pate - Morgan Stanley
Good morning, I am Cheryl Pate. I cover the Specialty and Consumer Finance Stocks here at Morgan Stanley, and it’s my pleasure to welcome MFA Financial to our conference this morning. MFA Financial is a hybrid mortgage REIT with a long track record, formed in 1998 as one of the few mortgage REITs operating today that has been in the business through the full interest rate cycle. MFA invests in both agency and non-agency RMBS and is an internally managed REIT.
With us today to present for MFA is Bill Gorin, Chief Executive Officer and Craig Knutson, President and COO. And with that I’d like to pass it over to Bill and Craig.
Thanks Cheryl. Thanks for the introduction and thanks for having us here. Your opening introduction reminded me of my one man battle against the term hybrid mortgage REIT. I believe that what we do is we focus on residential mortgage assets and find the best opportunities and if other people exclude non-agencies, perhaps sometimes they are detriment. So I don’t believe in a hybrid concept. I believe in we look for the best investment opportunities across the residential mortgage asset universe.
So we’re internally managed. We’re a REIT and we deliver shareholder value through both the generation of distributable income and through asset performance linked to improvements in residential mortgage credit fundamentals. So because we purchase agencies and non-agencies, not everything is purchased out of premium. Some assets are purchased at large discounts and that’s why in addition to distributable income we’re also generating value appreciations through the asset performance.
Here you see our historic returns and since January 2000 our annual return is 15.9%. So usually when you quote a periodical, you’ll be quoting Bloomberg these days, but I'm going to quote the New York Times. They took a look at rate of return owning the Clippers. So the Clippers were purchased for $12.5 million and their pending lawsuits might be sold for much as $2 billion. The rate of return on that -- it was a 31 year holding period -- was about 16%. So you still lose the concept of how important 15.9% is and what that does over time when you compound. So if you reinvest your dividends we’re compounding at a good rate and -- the good example are the Clippers and what close to 60% return does over time.
First quarter, we continue to generate consistent and attractive results despite the low interest rate environment. The first quarter earnings per share and the dividend per share were both $0.20. Credit fundamentals on our non-agency MBS portfolio continue to improve. So some of you might have caught Janet Yellen’s presentation in New York at The Economics Club. And what she did was, she would quote the blue chip forecast of economic interest rates over the next couple of years, but she did it over time. She’d tell us when these blue chip forecasts came out. So over time every year -- analyst forecast interest rates will be higher two years from now and that’s been the case for the last six years.
So it’s hard to forecast exactly where interest rates are going to be, because the Fed will make their decisions based on data on labor markets, inflation of the economic data. Therefore we have to be positioned to understand that we can't perfectly predict where interest rates will be. So do we do that? One, we have a very low leverage ratio 2.9:1 and two-thirds of our MBS portfolio are either adjustable rate or hybrid. Hybrid means fixed for a period of time and then adjustable.
So in the last slide I said consistent returns. What does that mean? Consistent returns despite a low interest rate environment. So let’s look at the yields on interest earnings assets over the last five quarters; consistently over 4%, pretty consistent with a slight upward trend. Now why is that? If interest rates are going down, you have high yielding assets running off and you have to replace them in the marketplace? Why is it our yield is going up. It’s because the yields in our existing portfolio of non-agencies continues to go up due to the fact that the underlying credit continues to perform better than we initially expected. We therefore could change our assumptions on the yield on the non-agencies have trended up.
That pretty much explains why our spreads have also gone up. So there has been no spread compression despite the low interest rate environment. In fact spreads have trended up somewhat over the last five quarters. When you look at the debt to equity ratio, so increasing yields, increasing spreads. We don’t have to increase our leverage to generate earnings. Our leverage has stayed flat or actually has gone down a bit.
We mentioned asset performance in addition to distributing the high coupon. So what happens where book value in the first quarter went up primarily due to appreciation in the non-agency portfolio? You’ll see that net income was $0.20. We dividended about $0.20. Our agencies appreciated $0.05, our non-agencies appreciated $0.13 per share. Hedge is pretty much equal to the appreciation in the agencies and therefore the change as I said was due to the appreciation in the non-agency portfolio.
So here we look at how we measure our interest rate sensitivity measured by duration. Duration of the company remains below 1. I can put this on a slide and explain it to you but what’s more important is actually what happened last year. If you remember last May and June was a busy time in the interest rate market, that’s when Fed Tapering talk started, and rates I think were low as about 1.6 in May and quickly went up to about 2% in June and we held onto our book value consistent with our duration calculations.
So when you look at duration for non-agency assets, it’s hard to calculate it based on historical data; because typically you didn’t have assets that were created as AAAs, senior most piece of the tranche, high coupon that traded at very low prices. So the fact that you're buying buy assets at discounts, you don’t have lot of empirical data or historical data as to what happens when interest rates change. Now during most of the life of these assets since we’ve owned them, there has been no duration or negative duration. When the economy looked like it was doing better and interest rates were trending up, non-agency assets were actually gaining value because people were changing their credit assumptions.
But based on the fact that the prices of these assets have appreciated and the fact that we do want to be conservative, we now assume some duration for the non-agency assets. As a result we did increase our use of hedges and swaps in the second half of last year.
Turing to Page 9, we look at how we’ve allocated our equity, how we look at our spreads and for the first time in this quarter we actually added this third column which is new securities created off pre-existing, re-performing and non-performing loans. Going column by column, first column is agency MBS. There we run with about 7.3 times debt-to-equity ratio. We have about 800 million of our equity allocated to this space. The yield is 2.39 and the spread is 1.18.
Next column is non-agencies. There we have a market value of about $5 billion and this is where we’ve allocated most of our equities. This is the asset class that we’re most interested in. We have more than $2 billion of equity allocated to this asset class. Leverage ratio is $1.35. Now that’s trended down, and the trend down is due to two things. One the assets appreciate. So equity growth, so your leverage goes down. And two, when we started buying these assets, initially there actually was no leverage available in the asset class. Once leverage did come, typically we put on the leverage when we could. So you bought the asset, you put on the leverage. Now because there is people competing to lend this money against the non-agency assets, we’re using somewhat less leverage there, because we know we can add it when we want to.
The yield on these assets, this is loss adjusted. Before leverage the yield is 7.8%. Funding cost including allocated swaps is about 3%. So our spread is 480. So you see this is what’s helping to drive our superior returns in this period of time.
Third column or new securities backed by re-performing and non-performing loans. Now when these securities are created, it is about 50% subordination based amount. In addition typically, if the asset existed more than three years, the coupon will step up 300 basis points. So we can easily do the credit analysis here, with the 50% subordination and our understanding of ‘05, ‘06, ‘07 (indiscernible) loans. We’re very comfortable with the credit and with the fact that the interest rate, the coupon will go up 300 basis points three years from now. We’re very comfortable with the interest rate risk.
So this is a type of asset that we’ve added over the last six months or so, and this is an example of why we don’t limit ourselves just to agency assets, that we continue to find superior investment opportunities across the residential mortgage universe. Just skipping to the last column, you see that debt to equity ratio was about 3 and our net interest rate spread is approximately 2.5%.
And with that I’d like to hand the presentation over to Craig Knutson to talk about the credit senses of assets in our portfolio.
Thank you Bill. So as Bill mentioned, we’ve seen significant credit improvement in our non-agency portfolio and the most important measure that we used to look at this is the LTV, the loan to value ratio. And again the loan to value ratio, as I'm sure you know is a fraction where the numerator is the loan amount and the denominator is the property value. So we have actually two things, both of which are beneficial that are occurring.
The first is many of these loans, more than half of the portfolio is amortizing. So typically these hybrid arms, when they are first originated, if there are a 5.1%, they have an interest only period for the first five years. And after the first five years the coupon resets, people are conditioned to think that that reset will result in the coupon going up. But in fact the opposite happened. Because these loans originated in 2005, ‘06 and ‘07, so they were originated with typically 5.5% to 6% initial coupons and when they reset five years later, they reset at LIBOR plus 200. Well LIBOR was approximately 100 basis points when they reset. So the coupon actually reset down. However the loan also now starts to amortize. So it amortizes over a 25 year period.
So what does that mean? Well the payment shock that one might associate with a reset actually never occurred. The payment in many cases went down or stayed about the same. But more importantly the loans are now amortizing. And at that low rate they amortize to the effect of about 3% a year. So we have amortizations which lowers the loan amount. Again remember that’s the numerator of that fraction. So you reduce the numerator; obviously you recue the value of the fraction.
At the same time the denominator is the property value, and we’ve seen significant property value increases across the country, but in particular in places where we have a high portfolio concentration such as California which is about 46% of the portfolio. So as you have whole right depreciation, property values go up, the value of that’s nominator increases, again reducing that traction. So some very significant LTV improvements. As a result we have lowered our estimate for future losses in the portfolio and in the first quarter of this year, we transferred almost $36 million from our credit reserve to accretable discounts. Over the last five quarters it’s close to $250 million that we moved from the credit reserve to accretable discount.
So this is a little more on LTVs. So on the left hand side I would call your attention to the green line. So this is the whole, the total portfolio LTV. You can see that at the beginning of 2012, the portfolio LTV was in access of 105%. If you look back just a year to March 2013, the portfolio average LTV was about 95% and that’s now declined to about 80% in the last year. So very significant improvement there.
On the right hand side, I would call your attention to the orange line. Now the orange line is the current loan. And again the difference between these two, on the left hand side those are average LTVs as a whole portfolio. On the right hand side this is the percentage of loans with LTV’s greater than 100. So why do we care about this? Well if the average LTV is 95 and you have a loan that has a 135% LTV and you have another loan that has a 60% or 65% LTV, the average might be a 100 but you’re still at risk for the 135 LTV because that 60 or 65 LTV, the credit enhancement provided there doesn’t help out with the 135% LTV. So if you look at the current loans on the right hand side, that orange line and again go back to year, about 35% of the loans that were current had LTVs greater than a 100%. Now that number is down to about 15%.
And these are the loans that we worry about defaulting in the future. So I think the portfolio right now has about 16% of the loans that are delinquent and for the most part we assume that delinquent loans will get liquidated and will incur some losses. The challenge in predicting future cash flows is predicting how many of the loans that are current today will default in the future.
And the single best indicator that we have of that is the LTV. So if the LTV is very high, then there is either perhaps incentive for the homeowner to default or if the homeowner runs into distress, they have little incentive to try to keep the property since they have negative equity.
On the other hand if the LTV is below 100 or in some cases below 80 let's say, than the homeowner certainly has incentive to continue to make payments and even if that loan were to default, we would not expect to see the same loss severity that we would see on a high LTV.
So this shows the current loans in the portfolio. So again, these are the loans that are not delinquent today and the red bars on the right hand side are what I would call the at-risk loans. So you can see, and if I had shown you just a year ago, there would have been a lot more red on the right hand side here. So with this LTV improvement, we significantly reduce the amount of at-risk loans in the portfolio. And again, if you look over on the left there, it’s less than 60 and 60% to 80% LTV. It’s probably about $2.5 billion worth LTVs that are below 80%. Well, why is that significant? Well, because those borrowers are prime for refinance candidates. So -- and if they refinance, again remember we purchase this securities at significant discounts. So anytime someone refinances and we get paid off at par, that's a happy ton.
So finally this shows the accounting and how the accounting works. So over on the left you can see our purchase price is approximately 74% of par. So it’s average purchase price for the portfolio. So the purchase price is 74% but obviously the base amount is 100. So we have over a 26 point discount. So how do we account for that 26 point discount? Well over on the right hand side you can see that 18% of that 26% is set aside as a credit reserve.
So that credit reserve, despite the fact that we’ve moved significant monies from credit reserve to accretable discount in the past, that credit reserve is still over $1 billion or 18% of base. And you can see the purple part at the bottom there, that’s the discount that we accrete. So when we book income we book the coupon income on this securities plus some discount accretion which is that portion at the bottom. So as we move monies from our credit reserve to accretable discount that accretable discount portion of the interest increase over time.
The other way to look at that is on average we have a $74 price cost basis and because we have an 18 point credit reserve we’re basically accreting to 82. So we paid 74 and we’re expecting that we’ll get back approximately $0.82 on the dollar on these securities.
And that concludes the presentation. I’ll be happy to open it up to questions.
Cheryl Pate - Morgan Stanley
I’ll go ahead and kick off the Q&A. We spent a little bit of time on credit reserve at the end there and that’s obviously been a nice tailwind over the last several quarters? Can you maybe walk us through the methodology a little bit about how the decision was made to move from the credit reserve into accretable discount and the credit reserve as it stands today is tracking a little bit ahead of what the 100% LTV is. (Indiscernible) 16% versus 18%? So maybe just the methodology I think would be helpful?
Sure. So the methodology, we have a surveillance team which is a separate team from the investment team that basically does surveillance on the Non-Agency portfolio. And every single bond -- and we have over 600 line items, every single bond gets looked at in depth at least every three quarters and in some cases, in many cases actually they get looked at more frequently than that.
So for instance, if the bond has a low loan comp as 40 or 50 loans in the whole bond, then it’s hard to any statistical analysis because for instance prepayment, if we get one loan to prepaid, it could be a 40% CPR. Well that doesn’t mean that we're going to change our prepayment assumption because it was just one loan and it might be zero for the next three months, if we don’t see any.
So it’s a very intense process. Every single bond gets looked at. We drill down to loan levels and we’re really looking at this LTV improvement. So it's just sort of constant theme of LTVs and at end of the day our loss assumptions and the changes our loss assumptions are typically -- not exclusively but typically because we believe that fewer of the loans that are current today will default in the future.
And again as those LTVs drop down home owners have less incentive or have no incentive to default, and even if they do, the losses we would expect would be less significant than what the higher LTVs. As far as trying to match up the 18% credit reserve to the 16% delinquency, obviously the 16% delinquency, we don’t expect the 100% loss severity. Our loss severities are running still around 50% and that might surprise you, given that we’ve seen a home price appreciation. I think the biggest reason for that and the biggest reason that we haven’t seen loss severities tail off is because many of these loans have been delinquent for a very long period of time and so the services are advancing those coupons.
So in the case of a fixed rate bond, they are advancing a 6% coupon. So if the loan -- if the loan is delinquent for three years before its get liquidated between taxes, insurance, and coupons, there could be 20 or 25 points of loss severity associated solely with advancing and taxes and insurance. So we would expect over time as LTVs improve that those loss severities may improve overtime, but it hasn’t happened yet.
And again the reason that, that 18% is higher than the 16% is because we still have few -- I'll guess that, we probably assume that about 30% of the total loans in the portfolio default. So that’s 16 plus another 14 or so. So that’s why those numbers don’t really match up because again we still -- we still do assume that some of those loans that are current today will default in the future although that number is dropping and has dropped significantly.
Cheryl Pate - Morgan Stanley
Maybe just one for me before we open it up to the audience. Maybe we can spend a little bit of time where you’re seeing the best opportunities in the Non-Agency space. Obviously you have a nice portfolio from legacy, Non-Agency MBS and more recently the RPL/NPL opportunities. So maybe can just help us understand where the best yields are, where the best product availability is?
Sure. Well, the good news is the first quarter this year we saw a lot of investment opportunity. We grew the Non-Agency portfolio. We grew the Agency portfolio and we grew our investments in these new assets class that we described. So there are still new securities being created. Now May this year was similar to May of last year, where sometimes you’ve invested all your run-off, sometimes you’ve grown your portfolio and you don’t need to grow in a month or couple of weeks. And I would say we’re probably in that period right now where everything seems to be priced to aggressive assumptions. But we, fortunately we grew the portfolio to where we want to be and we only have to replace that 100 million of assets each month. So that’s not a challenge. But we’re not compelled grow the Company at the moment either.
Cheryl Pate - Morgan Stanley
Got it. Is there any question in the audience?
May I know your (indiscernible) of future. Do you intend to change your leverage ratio and your view about mortgage spread in the future?
So I believe your question talked about leverage and spreads. Is that correct? So the leverage has remained fairly consistent overtime. It’s never a question of gee, do we want to take the leverage up or down. It’s more a question of do we see assets that we want to acquire and how we’re going to capitalize it? Is it with equity or is it with leverage. I would say right now, we don’t see compelling reasons to grow the asset base. Therefore if the equity base remains consistent, the leverage ratio won’t change.
So it really is driven by the universe of assets that we see we want to acquire. It's is not a question gearing up. We want to solve for earnings, you want to solve for this dividend, let’s gear up. The Company has never been run that way. It's let’s make the best investment when there available, less so when there is less available, and the leverage sort of falls out of that. Its how much assets you want to have.
I think your question was also about spread, is that correct? Fortunately despite the low interest rate environment, we still have a good tailwind on the Non-Agency portfolio. So the yields have remained about the same. Funding costs have remained about the same. So the spreads remains fairly consistent. So we don’t see -- certainly we haven’t seen much change over the last five quarters.
Cheryl Pate - Morgan Stanley
Other questions in the room? Maybe one more for me. There has been increasing focus on funding costs and reducing the reliance on repo over time. Some of your peers have looked to FHLB funding. Is that something you’ve spent some time thinking about? Does it make sense on the Non-Agency portfolio?
Great question. So if you went back, six or seven years ago we were probably leveraged seven times. Before we diversify into Non-Agencies where the yield is so high, we use less leverage and still solve for an ROE of 9% to 11%. So we have not at all been constrained on repo balances. In fact in the second quarter of last year and the beginning of the third quarter, Bernanke was perplexed as to why his talk of potential taper impacted interest rates as much as they did and he thought that there was de-levering among the agency mortgage REITs. And I know the government did some investigative work and when they called us and they asked how much we de-levered? We said what do you mean? We were the ones buying the assets when the people were selling them. So that wasn’t our case.
There is talk and there seems to be a runway of three to four years as to what -- 1000 rules were due to bank balance sheets. Right now, repo is available in a plentiful basis and the funding cost incrementally has trended down. But in terms of people discussing, potentially diversifying, potentially qualifying for membership in federal home loan bank system; yes, we think about it, yes we think there is definitely merits to that strategy.
Cheryl Pate - Morgan Stanley
Any last question in the room? Just last one for me maybe. Your duration gap has been running sort of sub-one. What type of environment would you need to see to be comfortable taking that up a little bit?
Well, duration is only one number. It’s funny because you talked about where you have extra delinquent and Craig says its delinquencies time lost that matters. It’s duration times leverage that matters. So we look at how much equity is at risk due to changes in interest rates and that could impact our decisions. So for example, if we had perhaps less leverage, we might have little more duration. So we really look at how much equity is exposed. And I think in this -- the absolute interest rates are so low, when Craig and I first started working together that was 1981 and the day we showed up for work interest rates are 18%. So maybe that’s when we first introduced interest rate sensitivity. So I imagine with absolute rates so low in this period we want to keep the duration close to one or below one.
Cheryl Pate - Morgan Stanley
Great, well, please join me in thanking Bill and Craig for the presentation today. Thanks.
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