Good morning and welcome to the American Capital Mortgage Q2 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.
Thank you, Dana, and thank you all for joining American Capital Mortgage Investment Corp’s second 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 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 August 14th, by dialing 877-344-7529 using the conference ID 10049327.
Participating on today’s call are 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.
Thanks Hannah and thanks to all of you for joining us on MTGE second quarter earnings call. We are pleased with MTGE's results during the second quarter as economic return exceeded 7% driven by strength across both the agency and non-agency segments of the portfolio. During the quarter we saw treasury and swap rates continue to build flatten with longer term yields declining more than shorter term rates.
In contrary to the senses view at the beginning of the quarter agency MBS spreads tightened materially as the combination of low levels of mortgage supply and conservative investor positioning outweighed the impact of the Fed's tapering.
As we look ahead, we continue to believe that the supply outlook for agency mortgage market remains favorable and that the current valuations remain reasonable relative to other fixed income instruments especially after taking into account the liquidity and the financing benefits available on the agency mortgage market.
Credit sensitive bonds also remained very well behaved during the second quarter with almost all sectors materially tighter. Legacy non-agency mortgage backed securities were no exception with the price performance generally improving the further down the credit curve you went.
GSE risk sharing securities also performed very well during Q2. As we look forward, we see the technical factors remaining very supportive for most parts of the market. But as Aaron will discuss in a few minutes, we are becoming more cautious on some segments of the housing market.
Before reviewing our results, I wanted to spend a few minutes discussing the increase in our dollar roll position and the implications for our taxable earnings. During the quarter, we increased our dollar roll position to around 1.2 billion. As Chris will discuss in a few minutes, forward purchases of TBAs provide extremely attractive financing opportunities relative to agency repo. For tax purposes, dollar roll income is treated as realized gain on sale each time the TVA as rolled. As such the income is treated as capital gains or losses for tax purposes rather than as ordinary income as would be the case if we held that same mortgage position in full form and funded it with repo.
Realized gains on our TBAs are therefore netted against the accumulated tax loss carry forward that we incurred last year when we rebalanced a significant portion of our asset portfolio. Given the netting of these gains and losses, our taxable earnings will be materially lower and not reflective of our true economic performance.
Our taxable earnings will therefore not impact our decision with regard to where we set our dividends. We will continue to determine our dividend based on our view of the all-in economic earnings power of the portfolio and not based on earnings geography.
Now let’s turn to slide four, and I want to quickly review some high level results for the second quarter. GAAP income totaled $1.64 per share. Net spread income increased to $0.72 per share inclusive of $0.16 benefit from dollar roll income. Again net spread income excludes any cost associated with treasury swaptions and forward starting swaps. Taxable income came in at $0.45 per share for the quarter with the decline largely a function of the increase in dollar roll income which I mentioned earlier. As a result, undistributed taxable income decreased to $0.53 per share as of June 30th. Book value per share increased over 4% to $22.73 per share at the end of Q2.
Now turning to slide five, our portfolio totaled $6.8 billion as of June 30th and was comprised of $5.7 billion in agency mortgage securities, inclusive the forward TBA positions and around $1.1 billion in non-agencies. Our investments in MSR increased to $91 million in market value as of June 30th. Our at-risk leverage decreased to 5.2 times as of quarter end from 5.8 times as of March 31st.
Now if we turn to slide six, I think it would be instructive to look at MTGE’s returns since the announcement of QE3 and from its IPO.
First of all, year-to-date in 2014, we have generated an economic return of 11.9%. As you can see on the circle bar on the bottom chart, our 2014 performance improves our total post QE3 return to 23.6%. While this excludes changes in our price-to-book ratio, it is an outstanding result given the almost 100 basis points increase in interest rate and the significant volatility we have seen in the fixed income markets during this period.
Finally, as the last bar shows, MGTE has produced an average annual economic return of 20% since it's IPO in August 2011. This is a significant achievement for any investment vehicle, but is more impressive given that 2013 comprised approximately one-third of our total existence as a public company.
Turing to slide seven, we can see how our capital was deployed at the end of the second quarter. As you can see in the table on the top right, 62% of our capital was deploy toward agency MBS at quarter end. This includes both on balance sheet repo funded assets and forward TBS. Next 30% of our equity was allocated to non-agencies including GSE risk sharing positions. And then lastly, the capital dedicated to MSR and RCS as a whole increase during the quarter to about 8% as we added some more mortgage servicing rights to the balance sheet.
At this point, I will turn the call over to Aaron Pas to discuss our non-agency portfolio.
Thank you, Gary. As Gary mentioned, non-agency has perform very well in the second quarter with the universe returning about 2.75 percent. The market is benefited from favorable fundamentals and a strong technical landscape. Please turn to slide eight as I discuss the housing market and our portfolio composition. The housing market has remained supportive of non-agency assets with the year-to-date increase of around 5%. In general, housing is beginning to face some headwinds with bigger challenges generally existing in the lower price segment of the market. For younger adults, household formation has been low and real incomes remain under pressure.
Potential first time home buyers continue to face tight credit conditions, rising student debt levels and the shipment sentiment around owning versus renting. While we expect household formations to pickup with economic growth in the coming years, multi-family construction and even relatively modest single family construction over this period. We will likely be able to offset the bulk of the increased demand.
In addition, the demand for lower priced homes coming from investment funds that were specifically established to take advantage of the large influx of REO properties has begun to fall. This will have the biggest effect in certain regions and predominantly at lower price points where they have concentrated their investments. The combination of these negative factors appears to have impacted demand on lower priced homes over the last 12 months.
Looking to the chart on the upper right hand corner, we show the year-over-year change in existing home sales by house price segment averaged over the last three months. As can be clearly seen the demand for existing homes has been most robust in the highest priced segment of the market and weakest in the lowest priced segment. While this weakness hasn’t manifested itself in housing prices at this point, it will be important to watch how these trends evolve in the coming quarters.
In the near term, low transaction volume, domestic and foreign cash buyers and relatively strong momentum could cause house prices to outperform particularly in higher price portions of the conforming and jumbo markets. However in the medium term we believe housing growth rates will continue decelerate and we are more neutral on housing. On the credit investment side we remain in an environment where risk assets are generally at very tight levels across the entire spectrum. With double rounds of QE largely behind us, investors have been pushed out the risk spectrum with the rich for yield causing many of the highest yielding assets to be richest. Within the non-agency space, this has resulted in a relatively flat credit curve. Said another way, the spread we received on securities backed by subprime loans over more predictable cash flows is de minimis. As a result, we viewed subprime strong relative price performance as an opportunity to begin reducing our exposure to these securities.
With respect to portfolio composition, roughly 60% of the portfolio has direct exposure to housing, employment and the economy which will impact the level of cost and loss severity and in turn the amount of principle we will ultimately receive.
Given our current outlook on housing, it is critical to focus on geography and loan size. We've also targeted investments in assets that we believe have sufficient credit enhancement to withstand the range of housing and credit scenarios allowing us to run somewhat higher leverage as these securities benefit from stable cash flows and lower expected price volatility. These securities make up roughly 40% of the portfolio.
As it relates to GSE risk share deals there has been sizable issuance in the last few months. The GSEs have sold the risk off of about $150 billion of loans since March 31 and spreads are currently well of their types. At current valuations and purely on a fundamental basis, subordinate GSE risk share bonds look fair to achieve versus legacy non-agency assets. That being said, these two markets have significantly different supply technicals with the legacy market shrinking at each month and new supply coming to market in GSE risk share deals. As such, we would not be surprised to see a larger divergence in fundamental value between the two.
With that, I will turn the call over to Chris Kuehl to discuss the agency portfolio.
Thanks Aaron. Turning to slide nine the agency investment portfolio was 5.6 billion as of June 30th. At-risk leverage declined during the quarter from 7.8 to 6.8 due to a combination of net asset value appreciation, sales of other REIT equity and the preferred stock issuance in May.
As we discussed on our last call it was our expectation that agency MBS would benefit from strong supply and demand technical lower levels of implied volatility and attractive roll financing. Each of these factors continue to play a significant role during the second quarter and agency MBS performed extremely well.
Given the flattening rallying rated that continued into the second quarter we increased our 30 year position at the expense of selling higher coupon 71 arms and 15 year MBS. Quarter-over-quarter our combined 15 year and ARM position decreased from 46% to 36% to the portfolio.
The other notable change during the quarter is better TBA roll position increased to 1.2 billion as of June 30th up from 700 million as of the start of the quarter. While our roll valuations weakened in the month of July it weakened from extremely rich levels at the end of the second quarter and despite the relative weakness implied financing rates are still around 50 basis points through on balance sheet repo rates.
While we are likely approaching the end of QE3 the stock effect of the Fed nearly $1.7 trillion mortgage portfolio will continue to lend support as the fed will likely continue to reinvest pay downs well into 2015.
With that I'll turn the call over to Peter to discuss funding and risk management.
Thanks Chris. I'll begin with a review of our financing activities on slide 10. At quarter end our weighted average repo cost was 56 basis points down 2 basis points from the previous quarter. Breaking down that repo cost further the weighted average cost of our agency backed repo portfolio was 38 basis points down 2 basis points from last quarter and carry the weighted average maturity of 115 days. Our non-agency backed repo portfolio had a weighted average cost of 173 basis points and a weighted average maturity of 28 days roughly unchanged from last quarter.
On slide 11, we provide a summary of our hedge portfolio. Given the stability of rate and the modest changes to our asset composition the size of our hedge portfolio was relatively unchanged during the quarter. Overall, our hedge ratio fell slightly during the quarter to 86% from 90% last quarter.
Lastly on slide 12, we show our duration gap and our duration gap sensitivity. At quarter end, our duration gap was 1.2 years, down only slightly from the prior quarter. Similarly, our extension risk in the up 100 and 200 basis points scenario was also relatively unchanged on a quarter-over-quarter basis.
With that, I will turn the call back over to Gary.
Thanks, Peter. And at this point, I’d like to open up the call to questions.
Okay. We will now begin the question-and-answer session. (Operator Instructions). The first question comes from Doug Harter with Credit Suisse.
Douglas Harter - Credit Suisse
Thanks. When we’re looking out Gary, how should we think about the likelihood of change in your capital allocation? What areas do you find most attractive for kind of the incremental dollar right now?
Look, I think obviously it's going to vary with market conditions, but I wouldn't in the near-term expect a major change in the capital allocation across the various sectors. We are very comfortable with the technical landscape in the non-agency space even with kind of more neutral view on housing. We're very comfortable with that space but we have to be practical about the tightening we've seen in that sector.
The agency space, we are as well very comfortable with the technical landscape and we feel that space is absolutely fine on a relative value basis. And on the MSR piece, we will probably continue to grow that position, but in a patient matter. I mean I don't think you should look for a big quick increase on that front. So I mean obviously we’re going to be opportunistic with respect to relative value, but there is nothing I see in the very short run that will lead us to kind of a major change in that capital allocation anytime soon.
Douglas Harter - Credit Suisse
Great. And then on that MSR piece, I mean can you talk about what the timeframe till that business can sort of be earning an adequate return on the capital you have allocated to it?
Sure. Look, I think it's going to depend on how quickly we ramp up the size of the MSR book, how successful we are controlling costs in the servicing operations. So, we're not going to -- we can't give you a date, but the way I would think about it is, if you just think about the cost associated with that operation and you think about it in terms of the flexibility that it gives us over the long run; and I think what we believe and what we have told investors over the past year is MSR is something that is going to be a part of our investments for the long-term and that we think will produce very attractive returns. Right now there has been a fair amount of capital that’s been dedicated to the space. And so it is our view that MSR pricing will improve and it’s probably not that far away, maybe the early part of 2015 where I think we may start to see some pretty good opportunities to add more MSR. We have obviously added some, we will continue to add some and then that pace could pick up to the extent that the pricing dynamics improve on that front.
Douglas Harter - Credit Suisse
Great, thank you Gary.
Our next question comes from Trevor Cranston with JMP Securities.
Trevor Cranston - JMP Securities
Hi, thanks. One quick follow-up on the MSRs. You just mentioned that pricing was not necessarily the most attractive to you right now although you’re still adding some to the portfolio. Can you just comment on kind of where you see yields now and also provide some general commentary in terms of if you are seeing any opportunities to enter into something like a new flow purchase agreement or if you are mostly kind of just finding some old book deals to buy?
Unidentified Company Representative
Sure. So as Gary mentioned, valuations held up really well into the second quarter given lower rates, flatter yield curve, new production, 30 year MSRs kind of in the 4.5 to 5 multiple range. We are and as Gary said, we are being patient with respect to additions. We do have a small flow agreement in place; we're working on others as well, but nothing really further to add on that front.
I mean one thing to keep in mind around the MSR piece as we've obviously seen a decrease in interest rates as we've talked about over the course of the year, a flattening of the yield curve, which obviously increases the kind of inherent prepayment risk in mortgages and therefore on the MSR side. And that hasn't been reflected in MSR -- fully reflected in MSR prices. And it also doesn't -- MSR doesn't really distinguish well between kind of the newer higher coupons versus the older lower coupons. And so that's one of the things that's kind of certainly delaying us getting more fully invested on the MSR side.
The other thing is that we are very focused on getting the right kind of issue diversification around issuers and for a number of reasons, I mean you have to be focused on the prepayment behavior of certain issuers, you also generally want to not have a concentration in one particular issuer or a few particular issuers, especially if they have more questionable prepayments characteristics or if you’re even concerned about rep and warranties and so forth. So, for a number of reasons, again both pricing, but also concentration issues that make sense for us to be somewhat slower.
Trevor Cranston - JMP Securities
Okay, that makes sense. And then on the non-agency side, you talked a bit about the changes in the sub-prime and option ARM portfolios. On page 23 of the deck, it looks like there is also quite a bit of turnover in the prime bucket. Could you just talk a little bit about kind of what was driving that activity?
So, the turnover that you are pointing to on page 23 is largely a function of some trading in the GSE risk share securities. I think that made up about 100 million of the acquisitions in dispositions.
Trevor Cranston - JMP Securities
Got okay. And then last thing just small one in the AGNC slide deck you guys had a nice little chart about the EPS impact of changes in the roll specialness. Do you guys have an estimate for what the impact could be for MTGE, if for instance the specials decreased basically not being special at all?
Yeah it's going to be about 3 basis points in that zip code, 3 or 4 I mean it’s basically similar ratios.
Trevor Cranston - JMP Securities
Okay. Thank you.
And our last question comes from the line of Mike Widner with KBW.
Mike Widner - KBW
Hey thanks Gary I think you actually answered my question I was also going to ask about the servicing operation broadly and generally when we should -- how should we think about that getting back to profitability. But I am not sure you have anything else that on that I think you sort of answered it. But I guess I'll give you the chance to comment on it generally or what we should expect at least in terms of, should we model it at a modest loss or trail it to breakeven by year-end or next year anything sort of like that?
Yeah look I would say just going back to what we said earlier, I wouldn't expect an immediate change big changes over the near term. Again we view that aggregate cost is being very manageable when you consider the long run benefits of something that outpace one of the end and that we think and add value portfolio over the long-term.
Mike Widner - KBW
Yeah I mean thanks I got this is about what you said in terms of the actual cost I mean should we – and as a component of cost it’s going to be fixed of course now there is a component that’s going to be proportional to the size of the MSR book. I mean I think what I hear you’re saying on the MSR book itself is probably not in terms of underlying principal balance, probably not growing dramatically in the near-term just because of the prices on matter, shall we say full, but I mean anything about the fixed cost I mean you’re trying to cut cost out of the operation as we model the cost, I don’t know, that’s the question is there anything we should think about with regard to the fixed cost piece of that business?
We are obviously looking at the cost associated with running the business and I think you will see some improvements there but I don’t want you to, well I don’t want to give you the, there are some onetime cost but then there are things that can go in the other direction. So what I would say is I wouldn’t recommend that you model like major changes in that. But it is absolutely a focus of ours to streamline operations and to improve the cost benefit equation. But I don’t want to like give you anything to immediately kind of do in terms of modeling.
Mike Widner - KBW
Yes. I know, that’s that what I expected and I guess the other one as long as I am here is any comments on sort of equity investments and other REITs at this point and how do you think about those going forward and at current valuations where are the other with the sector is kind of trading today?
Look, what I would say on the equity investments is, we are totally comfortable when we got involved when we were buying, we were making equity investments and other REITs we were in the 80% of book area, nothing has changed with respect to being willing to invest in either buying back our own stock or buying the shares of other REITs with the same kind of equation that we have before. And as we've kind of said in the past at a 100% of book the same logic doesn't apply and so we're not likely to be an investor at that point. And again I'm not going to kind of fill in the whole spectrum in between.
Mike Widner - KBW
Yes, now makes sense. I appreciate the comments and color as always.
Alright, great. Thanks.
We have now completed the question-and-answer session. I'd like to turn the call back over to Gary Kain for concluding remarks.
I'd like to thank everyone for joining us on the MTGE second quarter earnings call. And we look forward to talking to you again next quarter.
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 August 14 by dialing 877-344-7529 using the conference ID 10049327. Thank you for joining today's call. You may now disconnect.
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