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Hatteras Financial Corp. (NYSE:HTS)

Q3 2010 Earnings Conference Call

October 27, 2010 10 AM ET

Executives

Mark Collinson – Partner. CCG Investor Relations

Michael Hough – CEO

Kenneth Steele – CFO, Treasurer and Secretary

Ben Hough – President and COO

Analysts

Mike Widner – Stifel Nicolaus

Bose George – KBW

Jason Arnold – RBC Capital Markets

Daniel Furtado – Jefferies & Co.

Steve Delaney – JMP Securities

Jim Ballan – Lazard Capital Markets

Henry Coffey – Sterne, Agee

Michael Taiano – Sandler O’Neill

Matthew Howlett – Macquarie

Kenneth Bruce – Bank of America Merrill Lynch

Operator

Good morning and welcome to the Hatteras Financial Corporation Q3 Earnings Conference Call and Webcast. (Operator Instructions). Please note this event is being recorded.

I now would like to turn the conference over to Mark Collinson. Mr. Collinson, please go ahead.

Mark Collinson

Thanks, Annie. Good morning, everyone. Welcome to the Hatteras third quarter earnings conference call. With me today as usual are the company’s Chairman, Chief Executive Officer, Michael Hough; the company’s President and Chief Operating Officer, Ben Hough; and the company’s Chief Financial Officer, Kenneth Steele. Also available to answer your questions are the company’s Co-Chief Investment Officers, Bill Gibbs and Fred Boos.

Before I hand the call over to them I need to remind all of you that any forward-looking statements made during today’s call are subject to risk and uncertainties, which are discussed at length in our annual and quarterly SEC filings. Actual events and results can differ materially from these forward-looking statements.

Also the content of this conference call also contains time-sensitive information that’s accurate only as of today, Wednesday, October the 27th, 2010 and the company undertakes no obligations to make any revisions to these statements or update these statements to reflect events or circumstances occurring after this conference call. That’s all from me. Here is Michael Hough.

Michael Hough

Hey, good morning and thank you all for participating in our third quarter earnings call. As usual, we have the entire Hatteras management team on the call to answer any and all questions you may have. But first, we’d like to a few minutes of prepared remarks that will highlight the operations of the quarter.

There are a lot of things we can talk about this morning, but I really want to focus on what has transpired in the market and what it means for Hatteras and how we are positioning things.

The completion of the GSE buyback program, the coming of investment, the continued shift lower of the yield curve and the uncertainty of economic and policy direction are all drivers of performance. All these taken together have served to tight margins on existing asset liability models, but at the same time, this created an opportunity that we are trying to exploit.

Recently, we have gradually positioned the company more defensively as the cycle has matured and will continue to do so. However, we feel like we’re getting such a good opportunity today to lock in spread that we always need to step back and remain cautious about all possible outcomes. But we are comfortable for now with our leverage and our portfolio mix.

As you know, we recently completed our first capital raise since December 2008. Hatteras realized net proceeds of 206 million on September 21st that was accretive to book value, aid [ph] in capital per share and ROE and permanent lowers our expense ratio.

Most importantly, in our view, that any assets and liabilities we’ve acquired with this capital will serve to extend the strong earnings environment we enjoy now. This along with the growth of Hatteras’ book value and asset pricing, we saw with an opportunity that would improve the long-term performance of our company. All without a material change to the existing asset liability mix and our risk posture.

The assets we bought with the proceeds will most likely be the most stable and predictable bonds we’ve ever bought and that allows us to hedge those funds more aggressively and for a longer period of time than in the past. We expect recently issued via one arm paper to behave more like a bullet with longer durations than existing paper and we think our prepayment assumptions should be more accurate.

Since we like the hedge longer, we can therefore match cash flows for a more true and predictable hedge. The capital was received at the end of September and for the most part, we have the securities trades done. Much of the paper has involved early on and an attractive pricing relative to today’s market.

Even though we have the bonds purchased, it is important to note that they will settle throughout the fourth quarter with the majority of the bonds settling in December. Leverage is September 30th, was 5.6 and we expect it to be around seven by year end. The timing of this will likely drag earnings for the fourth quarter to the degree that the cash is not yet earning.

However, when the yield curve is steep like it is now, to benefit its settlement will be attractive pricing on bonds that come on the books at a gain. To make long-term economic and defensive decision when adding securities and hedges, a lot of can be short-term calls to trade off as long-term value.

But, now, I’ll hand the call over to Ken for a rundown in the third quarter.

Kenneth Steele

Thanks, Michael. Good morning, everyone and thanks again for joining us on the call today. This was a busy quarter operationally with several moving parts, which I will try to shed some lights on.

Our net income for the third quarter of 2010 was $43.2 million or $1.12 per share, an increase in $36.8 million or $1.01 per share for the second quarter of the year. General story for the third quarter was timing. Our net interest income was essentially unchanged from the second quarter as we dealt with reinvesting from the Fannie Mae and Freddie Mac buyback and from generally elevated pre-payment levels.

Buyback program, timing and duration dragged on into the quarter and we were initially cautious about our pace of reinvestment due to lack of clarity regarding government intrusion in the market. In addition, essentially, all of our purchases being done forward, we also removed a few at risk positions from the portfolio and therefore, we had to lag in reaching our targeted investment level.

I would say we considered Hatteras fully invested at the end of August, reaching what we think as a normalize run rate in September prior to our follow on offering. At September 30th, 2010, our portfolio of MBS was $7.6 billion with the average dollar price of $101.75 and a weighted average coupon of 4.29%, a 27-basis point coupon decrease from the June 30th portfolio of $6.5 billion with a coupon of 4.56%.

Prepayments and investment yields compressed the overall portfolio yield although at a lesser pace than from the previous quarter following 15 basis points from 3.85% in the second quarter to 3.7% in the third quarter.

Amortization expense fell $11.3 million this second quarter to $9.2 million in third quarter, still somewhat high than we might expect without government intervention. Our repayment rate for the third quarter was approximately 34% on an annualized basis, significantly less from the 45% rate from the second quarter.

Our cost of funds, they have two basis points from 155 to 153 as some of our earlier slots have runoff and have been replaced at lower rates. This led to an average – through an interest rate spread of 217 basis points following 13 basis points from the second quarter.

We also realized $6.7 million in capital gains on sales of approximately $288 million of our MBS.

Our G&A expense was right on our average at $3.4 million or an annualized rate of a 130 basis points on average equity for the quarter. We estimate that that rate to be lower closer to a 120 basis points in the fourth quarter due to our equity offer.

Our book value is unchanged compared to the previous quarter at $25.83. But the compoundance of that number shifted as it did. When you raise equity at a premium, you increase your paid in capital per share, basically making permanent some of your unrealized value. We think this is significant as it is a way to increase share price at the long-term. We grew our paid in capital per share or permanent book as we like to call it from $21.50 to $22.63 as a result of our equity sales, a 5.3% increase.

Our MBS value strength in some, but this rally was more than offset by the falling value of our interest rate swap. The spell as we extended the overall term of our swap book and the long end of the great curve drifted downward. The compoundance of our book value at September 30th, 2010, on a per share basis are $22.63 of common equity, negative $0.07 of retained earnings, $5.66 of unrealized gain on our MDS and an unrealized loss of $2.39 on our swap.

Our leverage spell with a debt to equity ratio at quarter end of 5.6:1 compared to 6.2:1 at June 30th. There again you see the effect of timing as all that we had significantly more REIT per our quarter end in the previous quarter or late September equity raise caused the ratio to be lower.

In summary, we were pleased with our performance as our fundamentals remain strong. We worked hard to take advantage of the opportunities and challenges of the quarter. We did play at a dollar and 10 dividends at the third quarter, which resulted in a yield of approximately 15.5% based on our September 30th, 2010 share price and how to return on average equity of 17.26%.

I’ll now turn the call over to Ben for details regarding the portfolio and our investment progress.

Ben Hough

Thanks, Kenneth. Good morning, everyone. As Michael mentioned, we have substantially all the proceeds from the capital raise invested prior to quarter end with much of it settling forward in the fourth quarter.

On September 30th, the ARMs portfolio totaled $7.6 billion not including the $2 billion that had yet to settle at that time. Though to update investment activity up to today, in addition to those $2 billion of forward settling bonds, we’ve also an additional $500 million of ARMs making that a total of $2.5 billion that now settle after the end of the quarter.

Of that about $600 million just settled in late October, $680 million currently slated for late November and about $1 billion per late December, with the rest in January. Keep in mind that as long as we choose to buy new issue ARMs in volume, the timing of settlement dates is important. New issue MBS typically settle in the last seven to 10 days in the month, so when we indicate a December settlement for example, we don’t begin earning interest until late in December.

So, whenever we have excess cash and are in the process of building leverage like in the third quarter with the reinvestment of the buybacks and then again this quarter with the capital raise, timing will be a factor. The ARMs we have bought recently should yield around 2.90 to 3% and should provide cash flows that are fairly predictable.

Looking at prepayments for the quarter, are 34% slightly above our expected range. The residual Fannie Mae buybacks in July pushed the average up. This July prepayments have trended back to around 29%, which when expressed in terms of CPRs is about 26.

Now, that the buyback should be fully behind us, we can once again focus more on voluntary prepayments for the rate driven. But like we have always done, we’ll continue to analyze the portfolio to keep an eye out for any candidates that it might make economic sense to swap and to more predictable securities.

We earn most of this type of paper at legacy low dollar prices below $101.5 [ph] with great yields and therefore have the luxury of holding on to them even at elevated prepayments deeds. But even so when risking high prices on particular bonds that we think have moved on to an exceptionally high prepayment risk category, it may make economic sense for us to capture that gain and not wait for them to be called from us at par.

Looking back over the last couple of months, out a few of the full we have previously sold, these things are very high prepayment deeds, so in those cases it turned out to have been the right call.

Today, investment opportunities are still attractive even at current levels, while yields on lower premium new 5-1s have recently declined. Four-year swap rates are followed by more and current repo rates are steady at around 28 basis points. So, we can still add well over 200 basis points of well hedge spread while at the same time prolonging our spread horizon into the future for the whole portfolio.

So, while we had most of the new capital invested in securities before September 30th, we have taken advantage of gradually following swap rates and layered in new hedges at even better rates to not only hedge the new asset purchases, but also to replace legacy swap runoff.

The third quarter, we added $1 billion of additional pay fix swaps and we had $200 million of swaps mature for a net addition of $800 million. That’s the end of the third quarter; we have also added an additional $200 million to the quarterly totals seen in our release. Some of these swaps settle in the first quarter, but in the meantime we’ll continue to mark them to market and we’ll get the book value protection they provide in the event rates shift higher.

Though all in, our swap book today totals $4.4 billion with a weighted average rate of $2.27 and an average maturity of 35 months, which compares favorably to last quarter, which was a rate of $2.61 and 29 months to maturity. We were to not execute any more swaps, our current hedge position would represent about 50% of our total funding book by the end of Q4 when our forward purchase is settled and are financed.

But more important than the percentage hedge, the recent swaps we have executed are for longer terms and a four to 4.5-year range, which I significantly added to the term of our overall hedge position.

Lastly, I’d like to point out that of the $4.4 billion of total swaps, $1 billion of them mature over the next 12 months and have an average rate of $3.41. The replacement of those hedges should further increase the term on our swaps book and bring down incremental hedge expense to help offset some of the inevitable yield compression we would expect in a low rate environment.

With that, I’ll turn it back over to Mark.

Michael Hough

Okay. Hopefully, there’s enough information here to help you for the next quarter or two. So, right now please feel free to ask any questions that you have that we can help clarify. Operator?

Question-and-Answer Session

Operator

(Operator Instructions).

Our first question comes from Mike Widner with Stifel Nicolaus. Please, go ahead.

Mike Widner – Stifel Nicolaus

Hey, good morning guys. Congrats on a solid quarter.

Michael Hough

Thank you, Mike.

Mike Widner – Stifel Nicolaus

So, first question, just wondering if you could provide a little more detail perhaps on the schedule of swap maturities. I know you said $1 billion over the next 12 months, but wondering if you could give you a breakdown sort of roughly by a quarter.

Kenneth Steele

Okay. Hey, Mike. It’s pretty well latter and pretty gradual as far as the amounts though. Though they’re spread out pretty evenly, almost monthly across that period, so it’s pretty close and the rates are staggered a little different. But I think it’s a fairly consistent pattern.

Mike Widner – Stifel Nicolaus

Got you. All right. And then just another one, on the forwards that you’re buying right now, I mean what we’ve been seeing in the market is I think roughly about a 24-basis point drop for each month. You buy four [ph] of them, is that the ballpark or higher or lower, any guidance you can give us on that?

Michael Hough

It got – Mike, it’s about around six or seven [inaudible] a month depending on the coupon and I think probably you’re in the ballpark with what you’re coming up with.

Mike Widner – Stifel Nicolaus

All right, great. Well, I appreciate it guys and I’ll back out and let other people ask some questions.

Michael Hough

Thanks, Mike.

Operator

Our next question is from Bose George with KBW. Please, go ahead.

Bose George – KBW

Hey, guys. Good morning. See I had a couple of things, one was just on the asset duration and net duration at the end of the quarter and whether there’s any changes in that.

Michael Hough

No, not really. I mean the durations – the expectations that go into our durations can shift around with prepayment expectations, but for the most part – no, I don’t see a significant change.

Kenneth Steele

It’s that the paper we’ve been putting on recently are going to have longer durations than our existing portfolio and as you guys, we’ve seen the net durations of the portfolio, you see them come in overtime, I think that’s what’s happening now as we’re putting on longer duration swaps against them. So, we’re down probably lower, slightly lower than we’ve been, but pretty consistent since the last quarter.

Bose George – KBW

But the new step, the net duration on that is sort of that half year range?

Kenneth Steele

It’s probably close, yes.

Bose George – KBW

Okay. And then actually switching – touching on Mike’s question again. Just when we calculate the tradeoff between that drop is that basically the lost interest income is coming in – we can kind of equate that with the gain that you’re gaining, sort of the drop in the price, you know until the thing settled. Is that the way to look at it?

Ben Hough

It’s a pretty efficient market. It’s going to be very close.

Bose George – KBW

Okay, great. Thanks.

Operator

Our next question is from Jason Arnold with RBC Capital Markets. Please, go ahead.

Jason Arnold – RBC Capital Markets

Hi, good morning, guys. Sort of just curious with the very low pay fix rates on swaps right now. Are you guys comfortable with the roughly 50% of your book you mentioned being swap? Would you consider increasing this just to take advantage and then I was also curious if you could give us the pay fix rates – I mean the $1 billion notional mix swaps that you are putting on.

Michael Hough

I guess the answer is yes, we are comfortable with about 50% number right now. That doesn’t necessarily reflect the absolute protection because the purpose really of our recent capital raise was to build the liability book longer and at cheaper rates. So, that’s now we get more protection in our overall more hedge.

But right now, we feel like at 50%, we do have dry powder if we want to do more from liquidity management standpoint and as we see the cycle mature. I think that’s where we will go with swaps going forward, but right now I think that is – I think we’re very comfortable with that number. Ben, though?

Ben Hough

Yes, and as far as the swaps we’ve added. I don’t have the exact number, but I think it’s going to be right in the range of $1.25 to $1.35 somewhere like that. We did about pretty low, though I think it’s going to be out over probably close to 50 or 50 to 56 months long in one of the quarter $1.35 range.

Jason Arnold – RBC Capital Markets

Okay. That’s a great rate for sure. Terrific, thank you for that. And then I was just curious if you could also talk a little bit more about the prepay assumptions you mentioned on the new issue MBS that you guys have here going forward?

Kenneth Steele

Hi, at least for the initial, this first year, we’re looking for very low prepay assumptions. As Ben mentioned, we’ve been buying new issue 5-1s and 7-1s forward. You’re looking at coupons in the average of $3 to 3.20. We’re expecting the prepays on that to come in very low, high single digit stuff to maybe 10 CPR.

Jason Arnold – RBC Capital Markets

Okay, terrific. Thank you very much.

Operator

Our next question is from Daniel Furtado with Jefferies. Please, go ahead.

Daniel Furtado – Jefferies & Co.

Good morning. Thanks for the time. Speaking of the $2 billion looking forward this, high single to 10 CPR, do you still have a ballpark estimate for how much that nets down the whack [ph] on the coupon due to amortization, if those forward prepayment rates come through?

Michael Hough

Are you trying to get to a yield calculation?

Daniel Furtado – Jefferies & Co.

Yes. Basically, trying to slap on the four-year swap rate, the $3.25 and the whack [ph] and kind of net that down to get kind of ballpark where these assets are going to be performing.

Michael Hough

Yes, we would expect to see – what we’re modeling is somewhere between $2.80 and $2.90 on the yield.

Daniel Furtado – Jefferies & Co.

Okay.

Kenneth Steele

And if you’re putting on the swaps, I use a blend there – once again of approximately 50% and the other 50% I would use, our 30-day funding right about of 38 basis points.

Daniel Furtado – Jefferies & Co.

Got you. Okay, perfect.

Kenneth Steele

It’s over 200 basis points net interest [inaudible].

Daniel Furtado – Jefferies & Co.

Okay. And then, do you mind firing off the October, November, December schedule for forward settlements, please.

Michael Hough

Yes, that’s in October, there was $600 million even. In November, it was $680 million and a right out $1 billion even at the moment so far for December. And then there’s …

Daniel Furtado – Jefferies & Co.

Perfect.

Michael Hough

A $200 plus million in January, that’s for January prepays we’re getting ahead of.

Daniel Furtado – Jefferies & Co.

Okay, excellent. And then my last question here is just some color surrounding the securities that you sold in the quarter. I mean is it – you touched on it briefly, but beside your concern regarding their forward prepay performance, was there any – could you generalize what those pools consisted or what were in those pools that had you concern versus other pools on your books?

Kenneth Steele

Sure. It was primarily 2009 production. I think there was a little bit of early 2010 as well. What concerned us was, you have the large drop in interest rates over the last three months, we’re looking at origination levels at historic lows. The thing that jumped out of us on the bonds that we sold, all of them were amortizing first. We’ve been seeing amortizing pools coming in twice as fast as IOs paper. So, the amortizing pools have been paying quickly.

In addition to that, there was a very high third party originators percentage in these pools. We’re seeing very high pay down rates when third party originator pools, in addition to that it was high loan balances. The higher the loan balance the cheaper it is to do the refund and percentage basis for the year – for the borrower. So, those were three of the characteristics that jumped out at us when we were reviewing our portfolio.

Daniel Furtado – Jefferies & Co.

Excellent. Thanks for the time. Nice quarter, talk to you soon.

Kenneth Steele

Thanks.

Operator

Our next question is from Steve Delaney with JMP Securities. Please, go ahead.

Steve Delaney – JMP Securities

Thanks. Good morning, guys. That answer to Daniel’s question about the color on the bonds that were sold, the at-risk bonds, were very helpful. That was really my question. So, I guess that sounds like maybe some more recent, like 2009 vintage type productions. Is that accurate?

Michael Hough

Exactly.

Steve Delaney – JMP Securities

Okay.

Michael Hough

[Inaudible].

Steve Delaney – JMP Securities

And so, how about like your older IOs, you know sort of the stuff that’s got more home for underwater equity, maybe your’07 to ‘08 kind of paper. You’re still seeing that you know pretty slow?

Kenneth Steele

I think what we’ve seen in terms of pay downs has been on the higher end of our 20 to 30 range, probably in the low 30. My guess would be primarily that from …

Steve Delaney – JMP Securities

Defaults.

Kenneth Steele

Exactly.

Steve Delaney – JMP Securities

Yes.

Kenneth Steele

Both our mortgages going into default again, pulled out because [ph] via Fannie and Freddie are doing that.

Steve Delaney – JMP Securities

Okay. And then the final thing guys, with the blend, with this new slower paper added, I think last quarter, you told us as far as just sort of and we’ll talk runoff rate rather than CPR. You were talking like how 20s, 30 kind of projected runoff rate. Is that still where we are with the addition of the slower paper?

Ben Hough

That’s it …

Steve Delaney – JMP Securities

If we would seize remodeling over the next couple of quarters?

Ben Hough

Yes, I think – actually, the new paper could pull it down just a little bit. But you know some of the like Bill say in the ‘09 and early 2010 paper may speed up a little bit. But I think that you know we still like our range of 20 to 30% and still probably could stay in the high ends of that range. But I think overtime, especially with some seasonal factors that could drip a little lower.

Steve Delaney – JMP Securities

Okay. All right, thanks a lot.

Operator

Our next question is from Jim Ballan with Lazard Capital. Please, go ahead.

Jim Ballan – Lazard Capital Markets

Hi, great. Thanks a lot. Just a couple of clarifying questions. One is the $500 million that you’ve purchase also today, is that part of the $600 million for October or those other after market purchases?

Michael Hough

No, that’s just to update investment activities since the end of September. So that’s above and beyond anything that is in our release and it could be – that $500 million could be scattered throughout October all the way through January. It’s just to bring that $2 billion up to $2.5 billion to give you an update up until today.

Jim Ballan – Lazard Capital Markets

Okay, great. Thanks. And then, the other question I have is given the dynamics of the market that we’ve been talking about. Just what your thought on continuing to sell assets going forward, it means this something that – I mean obviously there’s a lot of games in your book value right now. What are your thoughts on continuing to monetize those, over the coming quarters?

Michael Hough

We’re going to continue to evaluate the portfolio. We’ve looked at and identified the first batch of bonds that we sold that were most obvious to us in terms of potential fast pay and has been pointed out they did prepay fast after we sold them for the most part and there’s some other candidates in there that we’re watching closely right now that we may or may not sell. But it’s definitely an ongoing basis.

Jim Ballan – Lazard Capital Markets

Okay, terrific. Thanks a lot.

Operator

Our next question comes from Henry Coffey with Sterne, Agee. Please, go ahead, sir.

Henry Coffey – Sterne, Agee

Yes, good morning. Can you hear me clearly?

Michael Hough

Yes.

Henry Coffey – Sterne, Agee

Good. I won’t – we’ve got you on the speaker phone. Obviously, thanks for the way you laid this out. It’s extremely helpful. The one thing we weren’t looking at and just trying to get some color on, this is kind of all highlighted by one of your peers. The forward commitments don’t show up on your balance sheet in the payable yet or what the accounting that goes into that?

Ben Hough

Yes, those are accounted for as derivatives. We can’t bring those on to the balance sheet until all kind of – everything’s clarified as the settlement and so, it’s called an All in One Hedge, we just are basically matching your cash flows. So, you don’t run it through the income statement, it just gets market to market and shares net. But we do include a schedule in the financial statements [inaudible] if I can see the exact amount, we’ve got.

Henry Coffey – Sterne, Agee

So, it’s sort of a net position, its varied is the wrong [ph]. But you show a net position in there someplace for the – in essence for the value of the contract? But you don’t – you’re not recording the payable and gross dollar value?

Ben Hough

That’s correct. I mean if it’s a short settle, there are some things that we do that. But for most of them, when we’re purchasing out that part of the TBA is have to be accounted for as a derivative.

Henry Coffey – Sterne, Agee

And then of course when you actually settle, what you get is a small bargain purchase so to speak for the risk and the time that you – there’s no earnings gained here like some people are saying. It’s more just a – you bought a cheaper bond with a slightly better yield.

Ben Hough

Yes, that’s a good way to look at it.

Henry Coffey – Sterne, Agee

Great. And in terms of your view on future swaps with the rate here, are you more likely to go into the longer duration swaps as you did recently or what is your thought process sort of going forward?

Michael Hough

Yes, I think that’s what the opportunity is. is that the swaps are cheap, hedging is as cheap as it’s been especially on a relative basis and the fact that maybe some of this new paper is going to have slightly longer durations in our existing portfolio does give it that opportunity to lock in spread for longer period of time. So, going out the curve relative to short duration of our portfolio is an opportunity and we see it as something we should take advantage of.

Henry Coffey – Sterne, Agee

And just to turn back to what the other caller was asking you about. In terms of keeping your distributable high, you certainly have lots of gains in the portfolio on assets that you might want to sell anyway, is that the thought process or?

Michael Hough

No, it’s really not. I mean we like to have – we like to have the gains in the portfolio that’s leverageable equity for us and increases our earnings power. However, we come into a time like now there are going to be select securities that we’re going to have to seriously consider selling. But for the most part, we’re looking at that gain is something that we would like to keep an equity from a defensive position and from a leverageable position that would …

Henry Coffey – Sterne, Agee

Very well, thank you. This is also very helpful.

Operator

Our next question comes from Mike Taiano with Sandler O’Neill. Please, go ahead.

Michael Taiano – Sandler O’Neill

Hey, good morning. I just got a question on the swaps. So, the billing [ph] that you entered into in the third quarter relative to the $2 billion of forward commitments that you have, did that cost you anything in the quarter? In other words, did that weigh on your spread in the third quarter?

Michael Hough

No, I mean when we do forward settlements on some of those swaps, they don’t impact earnings until they settle. So, we do – just like the bonds, when we do what’s – it will be settle forward as swap, there is some rate give back that we have to accept before that forward settle. But we are trying to match-up, protect those values on the forward settling purchases and we also have a legacy swaps book that we are opportunistically replacing.

Michael Taiano – Sandler O’Neill

Okay, got it. And can you maybe give us sense, obviously, a lot of moving parts going forward in terms of the swaps rolling off, the new paper coming on. I mean is it your expectation at this point, just directionally do you expect the spread to trend lower in the fourth quarter that basically what you were saying?

Michael Hough

The spread on the portfolio?

Michael Taiano – Sandler O’Neill

Yes.

Michael Hough

I mean there is some spread compression as we reinvest cash flow. However, into the degree that we’re locking it up, I think the long-term spread is probably improving just because we’re able to lock it in for longer. But in the meantime, our spread is – I really don’t want to look forward on that, but it does, there are variables there that will bring it down a little bit.

Maybe you would say it’s on going, but it appears that maybe it’s something at a little bit slower pace right now.

Michael Taiano – Sandler O’Neill

Okay. Now, that’s helpful. And then just lastly in terms of leverage, you indicated you expect to be at seven times by the end of the year. Is that also sort of what you’re thinking going into 2011 as well?

Michael Hough

Yes, I think that’s probably a comfortable range for us in this market right now and that’s going to be our target in the near-term.

Michael Taiano – Sandler O’Neill

Great, thanks very much.

Michael Hough

Thanks.

Operator

Our next question is from Matthew Howlett with Macquarie. Please, go ahead.

Matthew Howlett – Macquarie

Hey, guys. Thanks for taking my question. Just to clarify, we had heard reports that sort of some of the new issue hybrids were coming out of the gate really fast. That has not been your experience on what you’ve purchased over the last several months.

Kenneth Steele

It depends on – it’s a bond by bond basis, like we said a little it earlier. The ones with the certain issuers tend to pay faster than others. Also, if you have high loan balances with high third-party originators, they tend to be fast as well. So, it really depends on which bonds you’re looking at.

Matthew Howlett – Macquarie

Okay. So, you’ve been really been able to sort of focus on the originators and lower loan balance and that’s something that’s really work in your advantage?

Kenneth Steele

Yes.

Matthew Howlett – Macquarie

Great. Okay, just ahead of QE2, I mean what can you tell us, I mean you know is there talk that they go by hybrids, you know, [inaudible] stuff. Any implications on that coming up?

Michael Hough

No, I mean our view is that Fed will likely to pursue additional accommodation at the next meeting. We think it’s been fairly well advertised that they’re going to steel towards treasuries and the two [ph] spends, we don’t think at this point they’ll migrate into MDS. We don’t think that’s the case. It’s obviously a possibility the Fed would never basically rule that out.

But as far as the spreads go, we think it’s heavily discounted in the marketplace right now in the curve. So, right now, we have auctions this week that are backing things up a little bit. But we think the QE2 will go gradually, at least that’s our view. Maybe $100 billion per quarter or rather per meeting I should say by the Fed. And we think the curve has already discounted that, it might flat a little bit further and that could bring origination rates down a little bit, but we watch that closely and we think origination rates right now is pretty much where they’re going to stay for the near-term.

Matthew Howlett – Macquarie

Great. And then just last question, I mean you guys are really beginning to grow and you’re going to get over the $10 billion market and so forth. At some point, I mean is there a threshold where internalizing the management structure make more economical sense. I mean is there anything that you can tell us in the way of longer term, the structure of Hatteras?

Michael Hough

I mean I don’t think from an economic sense, from Hatteras standpoint that internalizing would make any difference. I mean if you’d look at the agreement that the management the company has with Hatteras right now, it is a very straightforward, very shareholder-friendly and I mean it’s possible that there would be some changes there, but I just don’t view that that’s would be an economic driver for Hatteras to want to internalize. As we grow, that number is going to continue to go down.

Matthew Howlett – Macquarie

Right, exactly. Okay, great. Thanks, guys.

Michael Hough

Thanks, Matt.

Operator

(Operator Instructions) our next question comes from Kenneth Bruce of Bank of America. Please, go ahead.

Kenneth Bruce – Bank of America Merrill Lynch

Thanks. Good morning, guys.

Michael Hough

Hey, Ken.

Kenneth Bruce – Bank of America Merrill Lynch

I’m going to ask a fairly big picture question and I apologize for that because it maybe a little difficult to answer. If you look at the current environment, obviously there’s a lot of challenges that you guys have to work through and certain opportunities that obviously you can take advantage of as well. Certainly, you pointed out that the swaps cost or are extremely competitive and allow you to lock in for longer term.

But as you kind of think about what’s going on within the context of QE2 and what is the – what the Fed is trying to engineer here, were they may actually be successful and actually stimulate inflation at some point in the future. What do you think is the best environment for Hatteras to perform? Is it one where we see a steepening in the yield curve and in rates moving higher, which ultimately I think maybe benefit your portfolio probably best or is there some other environment that you think is kind of the ideal situation for your particular structure?

Michael Hough

That is a difficult question. On the way we look at it, it depends on what you want to say the ideal time for us and I think it boils down to what performance period you’re talking about. we look at this as a long-term business and how we perform long-term through the cycle, which is why we see today as an interesting opportunity that we can lockup spread you know as we’ve come this far, rates have come down maybe as far as they can go and we’re able to walk up spread longer than we have been able to in the past.

I mean there is dry powder on the liability side; there is dry powder with our low leverage. It’s a pretty ideal environment for us right now because we’re making a lot of money. But I would say that long-term, you know if you wanted to make a 10-year horizon and we look back 10 years over what we’ve been doing that I think volatility is a good thing and volatility creates steepness in the yield curve and that’s what we’re after and that’s what we take advantage of in different ways.

So, looking forward, it’s tough to say, but this is a great environment for us now just as 2009 was and 2008 was. I think we’re in a position to keep it going for a long period of time.

Kenneth Bruce – Bank of America Merrill Lynch

Yes, excellent. That was really it. Thank you all your other questions have been very helpful.

Michael Hough

Thanks.

Operator

(Operator Instructions)

Michael Hough

Okay, Annie?

Operator

We have no further questions. This concludes our Question-and-Answer Session. I would like to turn the conference over to Mr. Michael Hough for any closing remarks.

Michael Hough

No, that’s all. Thank you all for participating in the call and for your interest in Hatteras, and for all the good questions. Have a great day.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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Source: Hatteras Financial CEO Discusses Q3 2010 Results - Earnings Call Transcript

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