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Hatteras Financial Corporation (NYSE:HTS)

Q2 2014 Earnings Conference Call

July 23, 2014 10:00 AM ET

Executives

Mark Collinson - Senior Partner, Compass Investor Relations

Michael Hough - Chairman and CEO

Ken Steele - CFO, Secretary and Treasurer

Ben Hough - President and COO

Michael Buttner - MD - Asset/Liability Risk/Strategy

Fred Boos - EVP and CIO

Analysts

Steve DeLaney - JMP Securities

Richard Eckert - MLV & Company

Mike Widner - Keefe, Bruyette & Woods

Douglas Harter - Credit Suisse

Charles Nabhan - Wells Fargo Securities

Ken Bruce - Bank of America Merrill Lynch

Operator

Good day and welcome to the Hatteras Financial Second Quarter 2014 Earnings Conference 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 Mark Collinson, Compass Investor Relations. Please go ahead, sir.

Mark Collinson

Thanks, Laura. Good morning everyone, welcome to the Hatteras second quarter earnings conference call. With me today as usual are the Company’s Chairman and Chief Executive Officer, Michael Hough; the Company’s President and Chief Operating Officer, Ben Hough and the Company’s Chief Financial Officer, Ken Steele. Also available to answer your questions, the Company’s Chief Investment Officer, Fred Boos and Chief Risk Officer, Mike Buttner.

Before I hand the call over to them, I need to remind you all that any forward-looking statements made during today’s call are subject to risks 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 contains time-sensitive information that is accurate only as of today, July 23, 2014 and the Company undertakes no obligations to make any revisions to these statements or to update these statements to reflect events or circumstances occurring after this conference call.

That’s all from me. Here is CEO, Michael Hough.

Michael Hough

Hi. Good morning and thanks for being on our call today. As always, our team is here to answer any questions you have following some brief prepared remarks. So happy to be coming off another low volatility quarter and the second quarter results we’ll discuss here are pretty straight forward. Before getting into the details, I only want to say that the relative stability we’ve enjoyed this year have allowed us to methodically refine and tweak our risk tolerances and to continue work towards being prepared for long-term opportunities that may develop for our business. Right now the balance sheet is in the best position it has been for rising rates on both the income and duration sides which is the right place for us to be considering where we are in the cycle. This is how we expect to be set-up going forward at least until we have more clarity on the future path of the yield curve. The portfolio is in good shape, the business is strong, so I leave it there and let Ben and Ken quickly go over the financials and the portfolio.

Ken Steele

Thanks, Michael. Today, I want to quickly go over a few specific things that you may have questions about around our results for the quarter. The first is the summary table of our interest rate hedges which is in the press release. This schedules the summary of the positions that we have with our interest rate swaps in Eurodollar futures contracts. Just to be clear, the notional amounts shown are the weighted average effective amounts during that year and the rate shown is the weighted average fixed rate that we would pay for each of those periods.

Although they -- in total they are interchangeable instrument in economic respect, when taken in pieces the Eurodollar contract prices are not an average, they are easily converted to an average but the actual expense or income will occur in the period of effectiveness for that particular contract. Therefore it seems more meaningful to us to give you the actual rates that will generate cash flow during that specific period.

Also I want to again highlight that it is our mark-to-market losses they now flow through income. The most significant portion is due to the intricacies of accounting for our interest rate hedges. For example, our unrealized losses on Eurodollars totaled about $108 million year-to-date. Just letting that one item back to our year-to-date $6 million GAAP loss equaled a net income of $102 million easily demonstrating that the dividend is covered.

Another way to look at our performance is that we have paid out $1 in dividends and increased book value by $0.73 which is a 16% annualized return on equity so far this year. Our liquidity is strong and we will be reported in the Q at about 9.4% of asset and that we have a full risk, liquidity which includes all our TBAs it’s how we look at internally of 7.9%.

With that I’ll turn the call over to Ben for details on our portfolio and investments.

Ben Hough

Thank you, Ken. I’ll be brief as well, since there haven’t been major changes to the investment portfolio over the quarter. In summary, as rates moved lower we gradually got a little more defensive and tweaked both the asset and liability sides of the balance sheet to bring in our net duration a little tighter. Other than reinvesting repayments, the only note is that we reduced our bond position by about 1 billion, a half of which were sales of longer duration 71 ARMs and the other half 15 year TBAs resulting in the modest lead lower leverage quarter-over-quarter.

As for purchases, we’ve been focusing mostly on investing cash flow in the higher coupon 51. We have been getting about 200 million to 250 million per month of that need wholesale out of our direct agency ARM flow program we have with select originators. With this strategy, we are able to target production and have been able to acquire a significant amount of attractive 51 and 71 agency ARM pools that should perform well.

On the liability side, we added a few four to five year Eurodollar future hedges into the rate rally and also a seven year swaption as a short-term volatility hedge. By taking some of our longer duration assets off the table and adding to our hedge book, we are now operating at neutral on our asset and liability durations and also very tight and up a 100 scenario. It is notable that we have a lot of interest rate swaps maturing over the next four to six quarters, most of which have already been replaced with forward starting swaps in Eurodollar contracts.

Repo availability remains strong and one month rates have stayed consistently in the low 30 basis point range and we don’t see any immediate pressure over the near-term. As for prepayments, CPRs increased gradually over the quarter as expected, a 15.4 averaged CPR for the quarter breaks down monthly at a steady up trend of 13.7 in April, 15 in May and then 17 in June. Our July CPR increased again to 19.8. Some of this was seasonal and ketchup from first quarter’s very slow speed but depending on rates from here, we would expect to see repayments steady to a little slower than our July number over the next couple of months.

And looking at agency ARM supply, origination levels have picked up a little over the past year even as overall MBS production has dropped significantly. Recent production has been 5% to 6% of overall issuance, up from 3% to 4% in 2012 and ’13. While still light from an historical perspective supply is sufficient and liquidity in the sector has been good. With many investors shifting down the curve as the cycle matures, demand for ARMs is strong and we think that will continue going forward. So overall, technicals remain positive for the hybrid ARM sector. And lastly, we see today’s book value very close to where we ended the quarter.

So with that, I will turn it back over to Michael.

Michael Hough

Okay, that’s all for the prepared remarks and operator, we are prepared for any questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator Instructions) And our first question will come from Steve DeLaney of JMP Securities.

Steve DeLaney - JMP Securities

Hey. Good morning everyone and thanks for taking my question, I guess I will throw this out to Ken. I think you guys don’t give a say a specific disclosure on taxable earnings. But I wondered if you could make some general comments as to if you have an estimate of where taxable earnings maybe for the first six months of the year and are there any material differences between taxable earnings and the your own calculation of core EPS which appears to take away most of the unrealized items that would not affect taxable earnings? Thanks.

Ken Steele

Sure, Steve. You are right, the core pretty well approximates taxable. We do have carryovers from prior years though that would -- well from last year that would give us a little bit of flexibility. So we aren’t in a position where we are distributing right around where we think we need to but we do have flexibility there if things move one way or the other.

Steve DeLaney - JMP Securities

We can ask about that. So just looking at the first six months, obviously you’ve got a $1.27 core and paid out a $1, so obviously looks like you’ve kind of added to the cushion to the extent that you actually have some carryover from last year. But Ken, just to be clear, is it correct that you can carryover say 2014 taxable earnings can be carried forward so long as they are distributed before you file your 2014 income tax return?

Ken Steele

That is correct, but if we have losses from last year, which we have some losses from over-distributing based on earnings that we can reduce the amount that has to be paid out this year. And we have some flexibility either way is what I am trying to say and we are trying to look at sustainability a little bit with the dividend which is how we have talked about and we kind of make the position. It’s a good unfortunate way to get there, but a good position to be and once you are there to have this flexibility.

Steve DeLaney - JMP Securities

Got it. Well yes. Now so what I am hearing you say though is the carryover not necessarily carryover of positive taxable earnings but there could actually have been some losses carried forward as well?

Ken Steele

Correct.

Steve DeLaney - JMP Securities

Okay.

Ken Steele

Most of them are capital losses but we do have some other carryovers that give us some flexibility there.

Steve DeLaney - JMP Securities

Okay. So I guess Michael, am I hearing you say then that despite sort of the top-line core earnings which have been very strong that we should not necessarily assume that there will be any upward movement in the quarterly dividend or even maybe a cleanup special dividend, should we just assume that the $0.50 per quarter is where you guys are comfortable with the dividend between now and the end of the year?

Ken Steele

Yes. I think that’s fair considering what we have said in the past and what we’re doing.

Steve DeLaney - JMP Securities

Okay, great. Alright, thanks guys, I appreciate the comments.

Mark Collinson

Operator, it appears we’ve lost connection.

Operator

This is the operator are you able to hear me.

Mark Collinson

Yes we could hear now.

Operator

I apologize for that. Our next question is from Richard Eckert of MLV & Company.

Richard Eckert - MLV & Company

Okay. Thank you, thank you taking my call. I have a couple of quick questions, one was on your CPRs and clearly premium amortization expense, I guess they were a little higher than I was expecting, if that I am looking at the mortgage bankers association refi activity indicators and their origination volumes for like the first six months of the year, it just seems like your prepayment experience moved in the other direction as opposed to the industry as a whole. Is there anything you can say about that?

Ben Hough

Well, hey Rich, this is Ben. I would just say, it’s kind of a lot of this is seasonal and what we would expect and it’s right on top, pretty much where we predicted, a lot of it is ketchup from the really slow rates of the -- over the winter and early spring. So I don’t want to read too much into a run rate from here, but the seasonal aspect of it would bring it back down a little bit, if it follows the typical pattern that it does every -- most years. And so we would think it would be -- come down a little, there’s the housing activities slowed down a little bit and the refi index has been down for the most part. So there is the flattening of the curve and the move down in the 30 year rates, created a little bit of ARM to fix, move I believe but I think that that’s not going to a pattern, that’s going to be consistent for over the long-term. So we expect it to come down a little bit from here.

Richard Eckert - MLV & Company

Okay. Thank you. Second question is, you were talking about sourcing loans directly from originators, how exactly does that work, I mean I assume these are all agency allegeable loans and do you acquire those than ship them off to Freddie and Fannie they package them into securities, you buy the securities back. And who would pay the guarantee fee on those securities?

Ken Steele

Yes. So these are all conforming the securities, that we’re purchasing from these originators they have put everything through their process and worked with GSEs and with their -- with the GSEs getting is the security and agency security.

Michael Hough

Hey Rich and just to follow-up. We’re pricing their production everyday and we are not a contractual takeout until it becomes a security and until we face the GSEs on the tray not the originators.

Richard Eckert - MLV & Company

Okay.

Michael Hough

So that’s really we’re just getting the benefits of the origination without any of the pipeline process and between.

Richard Eckert - MLV & Company

Okay. Fair enough, thank you very much.

Operator

And our next question will come from Mike Widner of KBW.

Mike Widner - Keefe, Bruyette & Woods

Hey. Good morning guys. Let me follow-up a little bit kind of sort of on that last one, but you recently made some hires and have been talking about a sort of more whole loan originations probably outside of the agency loans, I didn’t see any commentary in the release about sort of where that stands and how you’re thinking about, just wondering if you could update us on, kind of where that is in the process and how you can think it might play out at this point?

Michael Hough

Hey, Mike. I think last call we were talking about just the initial foray into the idea and we’ve spent a lot of time this quarter, I mean, I think getting into a business we’re completely and yes, we hired Kent Willard and Mike Nardacci to build credit infrastructure that we have, that we’re going to need going forward. The reason we didn’t say anything because it wasn’t a material update this quarter. We haven’t completed the process. We haven’t pushed the loan so hopefully we will able to utilize what we build, sometime later this year. And we’ll have more information for you then.

Mike Widner - Keefe, Bruyette & Woods

Sounds good, so sort of taking it slowly and I don’t know cautiously I suppose not just pushing into it sounds like…?

Michael Hough

Yes. This is not a -- we don’t anticipate this to be a major part of the business and it is something that’s important for us to access to assets we hope and it’s just a strategic part of the business that we hope would be beneficial long-term, but as of right now, it is just a strategic move and a way we think we can access assets that fit within our portfolio.

Mike Widner - Keefe, Bruyette & Woods

Makes sense, so let me ask a different one. Just looking at the composition of the portfolio at this point you’ve got about 15% of your assets in -- it looks like 15-year TDAs, it looks like you don’t actually have settled ones or at least not much in the way of settled ones and then mostly dollar roll positions. I mean can you talk about the size of that position and sort of how do you think about the relative risk adjusted attractiveness of that versus being in your more traditionals kind of hybrid ARM cash securities?

Michael Hough

Yes, hi this is Mike. When we are looking at the 15 year, again we look at that as providing us with a little more liquidity and flexibility in the overall portfolio. And then we know that mortgage spreads are tight all across the sector, all spreads are tight. We still think that there is value in 15 years and what we’ve also seen is basically negative production in the 15 year sector. So then we look at the net spread we are earning basically the carry we are owning the TBA and we’re able to get a better financing rate through using the dollar roll mechanism. So when we look at that overall spread, the assets look attractive from the margin standpoint.

Ken Steele

From a liquidity perspective, 15 years allow us to quickly reduce leverage should we need to do that. We recall that these 15 year position TBAs are fully hedged. So we feel that we can quickly get out of these positions that we had to reduce leverage well that gives us some support in terms of additional support in terms of liquidity for the entire portfolio.

Ben Hough

And just to answer one other part of that, we’re up 15% on financing with rolls this quarter. We really have been limiting this to a fairly small part of the overall portfolio we think that will be something that continues. But it makes sense for us to overdo this at this point in time.

Mike Widner - Keefe, Bruyette & Woods

Yes I mean that makes sense. And I mean I guess just to give some people maybe that -- because, I hear occasional concerns from investors that it seems like a little bit of a departure from your more traditional core strategy and riding things down the curve et cetera. Could you maybe just illustrate the economics a little bit of all in effective net spread if you will of what you are seeing today in these dollar roles versus incremental investments that you might put into 71 ARMs for example today?

Ken Steele

Yes, but just on -- I will comment just on opportunities that there might come. 51 right now two and three quarter coupon gives us a NIM of about 140 basis points, 1.4%, 71 maybe 1.45%, this is NIM not yield. So 15 year on balance sheet you might be able to get about 155, 160 in terms of NIM, but the TBA dollar roll opportunity would increase that by about 50 basis points to 60 basis points.

Ben Hough

Yes, it’s all in the ultimate funding level so it’s a benefit of repo at 30 basis points versus a much lower rate that where we finance the 15 years at by using the dollar roll finance.

Ken Steele

And those are hedge numbers, not raw numbers too.

Mike Widner - Keefe, Bruyette & Woods

Yes and I guess just and that is consistent with what we are seeing and modeling ourselves elsewhere at the dollar roll market is just kind of hard to ignore right now given that by the numbers you laid out and again what we’re seeing elsewhere and running ourselves is about a 50 basis point effective yield premium for being in that business relative to on in the bonds and cash. So it makes sense to me and I think it was a nice quarter guys. Thanks.

Ken Steele

Hey, Mike I do want to say one thing just saw your note this morning and you estimated about a 5% differential between funding what…

Mike Widner - Keefe, Bruyette & Woods

$0.05.

Ken Steele

I am sorry $0.05 difference in pre-funding with all over the repo and that number is correct.

Mike Widner - Keefe, Bruyette & Woods

Well, thank you. It is good to know that I know what I am doing once in a while.

Operator

And the next question will come from Douglas Harter of Credit Suisse.

Douglas Harter - Credit Suisse

Thanks. I was hoping you could share kind of how you are thinking about leverage at this point and what would cause you to sort of dial it up or dial it back in the coming quarters?

Michael Hough

As we always talk about leveraging liquidity in the same sentence we have our liquidity and risk position where we want them especially considering the rate rally that we’ve had recently and where we are in the cycle. We want to be set up in a very conservative way today with as little rate risk as possible, but also being able to earn a reasonable dividend. And I think the range you’ve seen us in over the last few quarters is going to be where we’ll be for a while considering the condition state of things. So we’re slightly lower this period that last and I think you can anticipate a similar range going forward for a while.

Douglas Harter - Credit Suisse

Great, thank you.

Operator

And the next question will come from Charles Nabhan of Wells Fargo.

Charles Nabhan - Wells Fargo Securities

Good morning and thank you for taking my question. Most of my questions have been asked, but I was wondering, if you could give us a sense for where Z-spreads are for 51 and 71 products at the end of June? And where they stand relative to historical levels?

Ken Steele

So our Z-spreads on 51, 225s this is the cap levels are about low 20s and on 71s they are probably mid to high 20 Zs. Historically they have been in the 40, 50 Z range. So yes, they are tighter. They are not as tight as they were say April of 2013. And I should point out. I think we did on the last call too that option adjusted spreads, are still much wider than they were back in the spring of 2013. So there is still opportunity in ARMs from an early S basis and the spreads are not nearly as tight as they were say a year ago.

Charles Nabhan - Wells Fargo Securities

Okay. And if I could ask Mike’s question regarding dollar roll in a slightly different way, could you comment on the conditions you’re seeing in the market in general, in the latter half of Q2 and maybe end of July? And what your expectation are for back half of the year?

Michael Hough

Expectations of the dollar roll market?

Charles Nabhan - Wells Fargo Securities

In terms of specialness?

Michael Hough

Yes. May be it’s a touch softer than it was in the second quarter, but we still think that the environment for the dollar roll, financing will still be advantageous for us through the rest of the year.

Charles Nabhan - Wells Fargo Securities

Thank you very much guys, I appreciate it.

Operator

And our next question is from Ken Bruce with Bank of America.

Ken Bruce - Bank of America Merrill Lynch

Thanks. Good morning gentlemen. My question really is getting at -- you have had a fairly interesting market this year to say the least I think very different than many had expected with the rally in rates and it is I find it interesting that now we go from a point where we’re concerned about rates going higher. And I guess there is still that concern, but frankly with the flattening of the curve, it’s seemingly introduced maybe a different issue. So I am wondering, if we continue to see a relatively flat or maybe you know flatter curve going forward, if spreads remain tight, there’s obviously some reasons why they may not, but if they remain tight, what’s kind of the thought process in terms of how you either rotate in and around other asset classes or do you kind of continue to stay the course, how will you think about operating in a flatter curve environment?

Ben Hough

Yes. So we -- as we talked earlier in the call that we are set up and positioned in a defensive way against higher rates from here. I think that’s where -- I think that’s a prudent approach to where all asset liability managers should be at this point. But there is the risk that we have continue to pull flattener and that’s not the scenario that I think any financial institution really wants at this point in time, but our portfolio is set up to find in that environment as well. We’ll have to look at our portfolio and our hedge book as the conditions change and if that’s the case and adjust to it. But I think right now, I think we have room, up and down in rates to be able to generate extremely nice risk adjusted return.

Ken Bruce - Bank of America Merrill Lynch

Yes. It’s -- like I said, it’s been somewhat of an interesting year just from the context of what’s been driving the long end and now the Fed is not in a hurry to do anything in the front end I don’t want to suggest that we would expect that, but it just feels like now the market is worried about this flatter environment persisting. I guess the -- you would still expect at least on the margin that when QE eventually does, gets finalized and there is some normalization within the MBS market would you expect spreads to rise from here, I mean they have been tight and maybe they are not at all time tights, but it just feels like there maybe some potential for spreads to widen as some of the bigger buyers that we’ve all kind of know about are no longer really participating in the market on the long end or just in terms of acquiring assets?

Ben Hough

Yes. But as they keep in mind, they are still going to be reinvesting cash flow which will be a lot of support in this lower origination environment we’re in. So, obviously that is something that we pay attention to and there is always a risk in this business, but there is on our part of the yield curve, the short part of the yield curve, this happens at -- it falls in the rate cycle where investors are looking for defensive investments and while we are these spreads might not be at that all time norms they are also probably very normal at some cycles at this time just because demand really picks up. So there is a lot of demand on this part of the curve which we think will provide a lot of support regardless of what the Fed does and when they complete their exit from direct purchases.

Ken Bruce - Bank of America Merrill Lynch

And just in your set of asset classes have tend to be the kind of target of many large banks. Have you seen them any activity or any preference in terms of how the banks at large are kind of behaving in this sector?

Ben Hough

Well they definitely continue to shorten and have an appetite for ARMs and 15 year fix. We don’t see the banks on the longer part of the curve as much now as we did over the past few years. So right now it seems to be that the asset types are there and will continue to be there, as considering where we are in the rate cycle.

Ken Bruce - Bank of America Merrill Lynch

And maybe they actually see a pickup in loan growth, maybe there will not be so securities heavy, it feels like there has just been a big rotation in securities at a lot of the banks. So certainly been it’s something that we’ve been witnessing for an extended period of time now. So well, thank you for your comments and I will add to the congratulations on a good quarter. Thanks.

Ben Hough

Alright, thanks.

Operator

(Operator Instructions) I am showing no additional questions. I would like to turn the conference back over to Michael Hough for any closing remarks.

Michael Hough

Okay, well that concludes the second quarter call and we appreciate your interest as always and look forward to next quarter. 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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