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Hatteras Financial Corp (NYSE:HTS)

Q2 2011 Earnings Call

July 27, 2011 10:00 am ET

Executives

Frederick Boos - Co-Chief Investment Officer and Executive Vice President

Kenneth Steele - Chief Financial Officer, Principal Accounting Officer, Secretary and Treasurer

Benjamin Hough - President, Chief Operating Officer and Director

Mark Collinson - Partner

Michael Hough - Chairman and Chief Executive Officer

Analysts

Bose George - Keefe, Bruyette, & Woods, Inc.

Steven Delaney - JMP Securities LLC

Joel Houck

Jason Arnold - RBC Capital Markets, LLC

Michael Widner - Stifel, Nicolaus & Co., Inc.

Operator

Good morning, and welcome to the Hatteras Financial Q2 Earnings Conference Call and Webcast. [Operator Instructions] Please note that this event is being recorded. I now would like to turn the conference over to Mark Collinson, Partner, CCG Investor Relations Strategic Communications. Mr. Collinson, please go ahead.

Mark Collinson

Thank you, Pete. Good morning, everyone, and welcome to 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 are the company's Co-Chief Investment Officers, Bill Gibbs and Fred Boos.

Briefly 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 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. The content of this conference call also contains time-sensitive information that is accurate only as of today, July 27, 2011, 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. Thank you, and now over to Michael Hough.

Michael Hough

Good morning. Thank you all for being part of our call. As usual, we have the entire management team on the call to answer any and all questions you may have regarding our second quarter. We are very pleased with the second quarter results. We distributed another strong dividend and had nice book value appreciation, and all with a stronger and more defensive balance sheet. I'd like to quickly discuss what we're thinking as far as how we're positioning the company going forward. First is our continued push to match asset and liability estimated cash flows. As is obvious, we have continued with the use of 5/1 and 7/1 hybrid ARMs, feeling that we can effectively hedge extended durations with interest rate swaps. We can model and predict the mismatch pretty well given different scenarios. I'm not willing to sit here and make an interest rate bet much past the next 6 months so we're taking the tack as we always have of trying to have a balance sheet that shortens its way into a rising rate environment.

Now that possibility seems to keep getting pushed out further so we’ve added some duration on our assets with new purchases and new liabilities against them but not at the expense of net balance sheet exposure. In fact, we continue to gradually tighten that exposure. So hybrid service wellness pursuit but as always, we look at the other options that can serve the same function we’re looking for. Lesser hedged short reset paper for example in year end, longer hedged 15-year paper also were options that we constantly evaluate and may utilize at some point.

There's a lot of value in the portfolio we’ve built today though and one that many financial institutions would love to have at this point in the REIT cycle. Hatteras is the largest ARM portfolio of any REIT and larger than most banks of a similar or larger size. While its value may not immediately be measurable, we have something that interest rate risk managers need and would have a tough time replicating. But to address the current show going on in Washington, the debt talks are obviously creating a lot of uncertainty in the REIT markets, and we don't yet have a real sense of what the impact on treasury rates and credit spreads will be in the unlikely event that nothing gets resolved. If it happens though, we're happy to be on the short end of the yield curve and happy to be in a highly liquid position as a defense measure. Repo counterparties are assuring us that they will be there through this time and we are seeing very little, if any, change in terms to indicate anything different.

As far as raising additional capital, it just hasn't made as much sense as it did earlier this year because of less attractive investment opportunities. Our timing earlier in the year was very good and has served to really improve the overall nature of our balance sheet. But of course, we're always looking for ways to improve the portfolio and if the opportunity presents itself, we'll have to consider it. But since the rally in the treasury market, yields and premiums and ARMs and other options don't make as much sense as they did earlier in the year. Lower treasury yields have been the biggest driver of performance but the fundamentals on agency ARMs continue to be very strong. The plan has been increasing on a relative basis to fixed rate paper because of the steepness of the mortgage curve, but demand primarily from bank AO managers looks to remain strong especially as the cycle progresses. It’s possible we may see a backup in ARM rate as an opportunity to put more money to work. So with that, I'll hand the call over to Ken to quickly go over the numbers from the second quarter, followed by a portfolio and market update from Ben.

Kenneth Steele

Thanks, Michael. Good morning, everyone, and thanks again for joining us on the call today. As Michael mentioned, we are pleased to report another good quarter for Hatteras. Our net income for the second quarter of 2011 was $77.5 million or $1.04 per weighted average share, as compared to $57.2 million or $0.96 per weighted average share for the first quarter of the year. Our net interest income increased to $77.6 million in the second quarter, up from $61 million in the first quarter, as we have finished our investment purchases related to our first quarter common stock offerings. Our average MBS for the quarter was $15 billion, up from $10.8 billion in the first quarter. We did also sell approximately $360 million of securities during the quarter for a gain of $4.4 million.

At June 30, 2011, our portfolio of MBS had a weighted average cost basis of 102.39 and an estimated weighted average coupon of 3.61%, an 8 basis point coupon decrease from the March 31 portfolio coupon rate of 3.69%. The yield on our portfolio for the second quarter of 2011 was 3.03%, which was 17 basis points less than the first quarter rate of 3.2%. Amortization expense for the second quarter rose to $17.8 million, up from $12.9 million in the first quarter of the year. This expense however was on a significantly larger portfolio, and our repayment rate actually fell during the quarter. The repayment rate for the second quarter was approximately 19% on an annualized basis, down from 22% rate for the first quarter.

Our cost of funds was essentially unchanged at 1.06%. While our repo rates were lower, we added additional interest rate swaps, which offset the pickup we got to short-term rates. This led to an interest rate spread of 197 basis points for the second quarter of 2011, a decrease of 19 basis points from the first quarter of the year. Our G&A expenses were $4.5 million, falling to an annualized rate of 88 basis points on average equity for the quarter, a reflection of the economies of scale benefit from our efficient operating structure. Our leverage at quarter end was 7.4:1.

Book value on June 30, 2011, was $26.72, the highest quarterly close we've had to date and the third consecutive increase. This was up $0.61 from March 31 and $1.88 from December 31, 2010. While asset prices have increased meaningfully during this quarter, this was largely offset by the decrease in value for interest rate swaps as we added significant notional amount to our book. In summary, for the quarter we generated an annualized return on average equity of 15.4% and paid a $1 dividend. With that, I will turn the call over to Ben for details regarding the portfolio and our investment.

Benjamin Hough

Thanks, Ken. Good morning, everybody. It was a pretty steady quarter for us from a portfolio standpoint. While we didn't get to our target leverage on a settlement date basis until June, on a trade date basis, we had executed the majority of our purchases in late March and early April. We were very satisfied with our timing since rates generally fell throughout the quarter, and assets became more expensive. But by late May, our leverage ratio was about 7.1% and by late June, we were closer to our target range.

As has been the case for the last few quarters, we invested in 5/1s and 7/1s, mostly new issue paper, which we believe will give us the best trade-off between yield and duration. The breakdown was about 60% 5/1s and the rest 7/1s. For the quarter as a whole, we bought $3.9 billion in ARMs with a weighted average coupon of 3.42%, at an average price of about 102 3/4 and 67 months to initial reset date. Given the rate volatility, it has become increasingly important for us to be even more selective in our ARMs purchases to get those securities which we expect will perform well. One thing we have seen over the course of the last few months is that the new issue hybrid ARMs market is becoming increasingly tiered based on prepayment characteristics, such as third-party origination percentage and originator among other things. Most notably, some originators slightly seasoned production has been performing exceptionally better than others based on their business practices and pipeline efficiency.

As we have always done and as prepayment risk has recently increased, we have been actively culling the portfolio of those securities that shift into higher prepayment risk buckets and are replacing them with more stable paper. We will continue to do that as the landscape changes and evolves. As for prepayments, they were lower on average in the second quarter compared to the first, and we were fairly steady in the mid to high teens each month for an annualized percentage rate of 18.5%, which is a CPR of about 17. These lower prepayments reflect the high rates and lower refi activity during Q1. Like Michael mentioned, as rates have now moved lower again, we may see prepayments pick up in the third quarter back into the 20% to 30% range. Our July prepayment rate was towards the upper end of that range.

On the hedging side, we continue to do what we've been doing over the last few quarter; that is, systematically laddering in longer swaps out past the stated durations of our new asset so that when rates go higher and duration extends, cash flows are better matched. For example, like now, when prepayments are elevated the stated duration of our assets dropped significantly. But as all MBS investors know, when rates go up, which is of course, what we're hedging against, the duration will extend. A new issue 5/1 today with a base duration of 2.5 or so could quickly extend to a duration of out to 4 years when rates shift. That's what we want to hedge.

But we also know that the duration of ARMs shortens at a faster pace over time and locks down the yield curve quickly. That said, in the second quarter, we’ve added $1.2 billion in new swaps in the 4 to 4.5-year maturity range at an average rate of 1.79%. A steady drop in rates throughout most of the quarter allowed us to selectively execute those swaps into strength as rates moved lower. At the end of June, our total base load of swaps was $7.4 billion, with an average rate of 1.86% and 38 months to maturity. This represents 50% of our quarter end repo total. With that, I'll turn it back over to Michael.

Michael Hough

Okay, good. Operator, we're open for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And the first question comes from Bose George with KBW.

Bose George - Keefe, Bruyette, & Woods, Inc.

Had a couple of questions. First I just wanted to ask about incremental spreads. The spread was down a little bit during the quarter and I was just wondering if the second quarter spread is a reasonable run rate for stuff you're putting on now.

Michael Hough

New production or new originations, Bose, that we’re putting on today, we're looking at somewhere in the neighborhood of about a 280 to 285 yield. And if we hedge that out the way we're currently hedging the portfolio, you're still looking right around 200 basis points.

Bose George - Keefe, Bruyette, & Woods, Inc.

Okay, great. And then just switching to prepayments. I was wondering what the prepayments did, just in July.

Michael Hough

Prepayments went in July back up, like I mentioned, to the higher end of our range. It was a CPR of around 25.5% in July.

Bose George - Keefe, Bruyette, & Woods, Inc.

And then just finally on asset prices, just curious on how your portfolio prices have trended since quarter end.

Michael Hough

On the 5/1 since quarter end, I think you could probably assume somewhere around 3/8 to 1/2 point increase in value. And on the 7/1s, I would use somewhere in the neighborhood of 3/4 and 7/8 of a point.

Operator

The next question comes from Mike Widner from Stifel, Nicolaus.

Michael Widner - Stifel, Nicolaus & Co., Inc.

So just wondering if you could comment a little bit on the leverage here. Obviously, the environment is probably a little more uncertain than it has been recently, and you said about 7.4 leverage at the end of the quarter. How do you think about that going forward? Are you comfortable with that level? Maybe inching down, inching up. Any thoughts?

Michael Hough

I don't know if you remember last call, Mike, that we had ended the first quarter much lower leverage because of the capital raise, and we indicated that we wanted to be somewhere in the 7x to 7.5x levered, which from a liquidity standpoint is where we want to be where we’re highly liquid with the type of securities that we have. And I think that, that's where you're going to see us operate here for a while. There may be periods of time where we’ve chosen to pre-invest, anticipated cash flows. But for the most part from a risk measure, I think we're going to be somewhere in the 7x, 7.5x.

Michael Widner - Stifel, Nicolaus & Co., Inc.

And so I guess, and you toward the higher end of that right now at 7.4%, and that’s…

Benjamin Hough

Think about this. We just told you that we expect prepayments to be slightly higher in July and then in August, and that's kind of in anticipation of that, too. We're just staying ahead of the curve.

Michael Widner - Stifel, Nicolaus & Co., Inc.

Got you. So you guys, you mentioned that opportunities obviously in the first quarter for investment were better than they were -- incrementally better than they were from a spread perspective now. You guys didn't do capital rate in the second quarter. But I see you did do about 2.5 million shares of share growth, and it did look like that was probably ATM offerings. But I was just wondering if you could comment on that, what was that growth, and any sort of thoughts along those lines.

Michael Hough

At that time, we were fully invested in and saw a small opportunity, and we just used the ATM for a couple of days. It wasn't very aggressive. But the opportunities from a balance sheet perspective were -- they were more attractive earlier in the year. And as we today are putting money to work just to the extent of our cash flow, we don't see the greater opportunity from a portfolio perspective right now to do anything significant. So I think it's -- on a relative basis, the 200 basis point margin is still there. But from a risk standpoint, long-term performance standpoint of the portfolio, we think there's possibly better opportunities coming down the road. But we're not anxious to raise capital. We feel like we're in a great place. We've got a great portfolio today,

Kenneth Steele

Mike, just a brief qualification there. Part of that was the closing of the shoe from the March deal so that's why it looks like it's over 2 million shares.

Michael Widner - Stifel, Nicolaus & Co., Inc.

It didn't occur to me that the shoe may end up getting pushed. And I guess, just one final one, if I could. It's certainly hard to complain about the portfolio today, and it looks good, solid, strong, all the things you guys mentioned. You guys still have stuck primarily to hybrid ARMs, mostly 5/1, 7/1. Some of your peers have argued more in favor of at least getting into the 15-year margin. We've seen a number of them do that from a duration standpoint. There's an argument that those might be at least better behaved and also reasonably short on duration. So I'm just wondering how you guys think about asset mix, and if the 15 years kind of a product, do you think about and look at or if there's some reason that you're just not interested in that part of the market.

Michael Hough

We made a comment earlier in the introductory remarks that while we do look at all of our options, I don't think we've seriously considered the 30-year fixed part of the curve. But yes, 15 years securities are securities that from a current duration standpoint probably are very close to a 7/1 ARM, and you can make a point that there's slightly more spread. Our view is that it is something that could make sense on our portfolio and pay very well. But we also view the ARM as a security that shortens through time. And we don't know when rates are going to go up from here. And if it keeps getting pushed out, our durations are going to shorten as our swaps are. The 7/1 next year is a 6/1, then a 5/1, and that is an important characteristic of our portfolio. But if we feel like we can invest in 15-year fixed or selective parts of the 15-year curve and hedge them appropriately for extension potential when rates go up, that's something we'll do. It’s just that the relative -- the relative value just hasn't been there for us so far.

Michael Widner - Stifel, Nicolaus & Co., Inc.

I mean, related to that, I guess, the prepayment characteristics across products has obviously been quite a bit different between fixed and hybrids and all that recently. How much of the rise in prepayments that you’re seeing now do you suspect is due to people just trying to squeeze their refis in before conforming loan limits change, and the other stuff that's going to go on at the end of the year? And then any sort of thoughts on why hybrids might be exhibiting higher prepay tendencies than I don’t know what we’re seeing in fixed?

Michael Hough

Yes, Mike, as far as hybrids get a little faster than fixed product in terms of refi, if you look at the borrower in a hybrid ARM, typically the borrower is a little more sophisticated, and as such is going to be a little more interest rate sensitive. You tend to see ARMs will pay a little bit quicker, and when you get moves in interest rates like we saw over the last probably 3 months, you get that drop in rates and they’re going to take advantage of it. So you do see a little bit more interest rate sensitivity in the ARM borrower typically, and that's what we see.

Michael Widner - Stifel, Nicolaus & Co., Inc.

Glad to know that I'm personally more sophisticated than some of the guys that are in 15 years or in 30 years.

Michael Hough

Just going to make one more comment on the prepays there. The prepays in ARMs, as Bill said, inherently are going to be faster than the rest of the curve. But in our view, it's a good trade to have ARMs with slightly higher prepayments in a low-rate environment like we're in today in exchange for better income and book value protection in the future when rates are higher. So that's the trade-off that we make and we feel is valuable.

Michael Hough

And one addition to that is that the mortgage curve is very steep right now. You’ve got the 5/1s origination rate down to high 2 handles versus the 4.5, mid-4 handle 30-year, and that's going to entice borrowers to refi into ARMs and thus that causes refi rates or ARM rates to elevate slightly.

Operator

The next question comes from Joel Houck from Wells Fargo.

Joel Houck

I wonder if you guys could talk about kind of where your haircuts are on repo right now for your collateral, and remind us where that went in kind of the financial crisis when Carlyle blew up?

Frederick Boos

Sure, Joel. This is Fred. Let's go back to the crisis when haircuts on agency MBS were in the 2% -- 1% to 2% range. It quickly jumped to 5% to 7% back in the '08 area and have pretty much come down to the 4% to 5% range on average. That's not to say we don't have haircuts below that; we do with some of our counterparties. But let's call the average around 4% to 5%; that is pretty steady right now. We're not seeing any change in that. We're in touch with our counterparties throughout this period of uncertainty in terms of U.S. debt discussions. So our view is that they will remain -- haircuts will remain steady. That 4% to 5% reflects, in our view, a substantial amount of price volatility in MBS prices, and that's why they are at 4% to 5%. We think that's a sufficient amount of haircut vis-à-vis the volatility of prices ahead.

Joel Houck

Have you done anything maybe deleverage slightly ahead of this uncertainty with respect -- I don't know if it's so much the debt thing as it is the threat of a downgrade in the risk that spreads would widen. Are you being opportunistic, or is your viewpoint hey, we're comfortable with what we own; we're going to ride this thing through?

Frederick Boos

I think we're comfortable with what we own and we've -- our leverage does reflect a very high liquidity position relative to the type of securities we have. So we feel like we've got plenty of liquidity to offset any volatility we may see with the potential downgrade or uncertainty here. But we have not taken leverage down in anticipation. We just maintained low leverage.

Joel Houck

And then the last thing is, in your interest rate disclosures in the 10-Q, I'm going back to the March because the June is not out yet. But you give -- the sensitivity is in a band of plus one or minus one change in interest rates. You may not be prepared to talk about wider bands today on the call. If you are, that's great. But I guess, I would wonder and kind of ask if you could widen that out in the future Qs for perhaps movements plus 2%, minus 2%?

Frederick Boos

I think you can look at that and -- I mean, from the low rate, absolute low rates where we are right now on the -- they operate scenarios easier to model than a down 200, which makes sense, if that's what you're talking about. I don't know that we're going to show that differently in sensitivity tables, but it's always something. This work that we do every day is just not work that we’ve put out publicly but it's something we will consider and look to the market for guidance if that's something that's needed.

Mark Collinson

And Joel, remember that we are on the very short end of the curve already. And I think that going from up 100 to up 200, while yes, that's some incremental risk there for sure. But being the fact we are in ARMs only right now, I think that's a pretty sufficient analysis.

Joel Houck

I guess I was looking at it from the standpoint that if you showed the relatively muted impact that would work in your favor, obviously, as rates go higher, faster, convexity plays into more than duration so that's where I was going. But I appreciate the comments.

Operator

And the next question comes from Jason Arnold from RBC Capital Markets.

Jason Arnold - RBC Capital Markets, LLC

I just had a quick follow-up on the one you made, Michael, about the CPRs picking up this past month. Does it feel very transitory to you from that perspective, more seasonality and low rate move driving it here given that we're probably seeing some refi burnout, or maybe you can just expand some of your thoughts there a little bit?

Michael Hough

There has been a move down in rates pretty substantial since earlier this year, and I think that's where we're seeing the prepays for the most part. But we expect that it will burn itself out, but the one thing that we've seen in ARMs is that ARMs really have 2 options to refi, an ARM-to-ARM refi, or ARM-to-fix refi more so than what we see in the fixed rate is simply fix-to-fix. And so there’s been more options. The curve is steep. But I think once this flows through what we've seen in July that we mentioned, we'll probably see somewhat accelerated, not from July's numbers but over what we saw in the second quarter in August, and then we expect some burnout after that. But it's going to be rate-driven from here, that's for sure.

Operator

The next question comes from Steve Delaney from JMP Securities.

Steven Delaney - JMP Securities LLC

Joe, I wanted to talk about haircuts, and Joel got that on the table. Can you confirm are you still seeing low 20s kind of pricing for 30-day repo?

Michael Hough

Yes. That's correct, Steve. Maybe a widened out a bp or two here in the last day or so with the news headlines but yes, low 20s on one-month repo.

Steven Delaney - JMP Securities LLC

There are a couple of people out there with notes, talking about 6% haircut. It checks with the companies that confirm what you say that nobody's getting pressed on that yet. But I'm sure you're hearing that chatter as well that some of the 4 to 5 people are starting to talk 6; whether that's just precautionary because none of us really know what the valuations are going to do, depending on what comes out of Washington.

Michael Hough

Yes, a 6% haircut in the low leverage environment we're in really is not -- does not stress us in the near term.

Steven Delaney - JMP Securities LLC

You've got equity to assets probably somewhere around 12%, right?

Michael Hough

Yes.

Operator

And actually, there are no more questions at the present time. I'd like to turn the call back over to Michael Hough for any closing remarks.

Michael Hough

Thank you, all, for your time today and as always your interest in Hatteras Financial. So from all of us here, Ben, Ken, Bill, Fred and myself, we wish you a good day and a nice rest of the summer. Thanks.

Operator

Thank you. And that does conclude today's teleconference. You may now disconnect your phone lines. Thank you for participating, and have a nice day.

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