Two Harbors Investment's (TWO) CEO Tom Siering on Q4 2015 Results - Earnings Call Transcript

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Two Harbors Investment Corp. (NYSE:TWO)

Q4 2015 Earnings Conference Call

February 20, 2016 09:00 AM ET

Executives

July Hugen - Director of IR

Tom Siering - President and CEO

Brad Farrell - CFO

William Roth - CIO

Analysts

Doug Harter - Credit Suisse

Bose George - KBW

Trevor Cranston - JMP Securities

Rick Shane - JP Morgan

Ken Bruce - Bank of America Merrill Lynch

Brock Vandervliet - Nomura Securities

Joel Houck - Wells Fargo

Operator

Good day, ladies and gentlemen, and welcome to the Two Harbors Investment Corp Fourth Quarter 2015 Financial Results Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I’d like to introduce your host for today’s conference Ms. July Hugen, Director of Investor Relations. Ma’am, please go ahead.

July Hugen

Thank you, and good morning. Welcome to our fourth quarter 2015 financial results conference call. With me this morning are Tom Siering, President and Chief Executive Officer; Brad Farrell, Chief Financial Officer; and Bill Roth, Chief Investment Officer.

After my introductory comments, Tom will provide a recap of our fourth quarter and full year 2015 results, Brad will highlight some key items from our financials, and Bill will review our portfolio performance. The press release and financial tables associated with today’s conference call were filed yesterday with the SEC. If you do not have a copy, you may find them on our website and the SEC’s website. This call is being broadcast live over the Internet and may be accessed on our website in the Investor Relations section under the Events and Presentations link. We encourage you to reference the accompanying presentation to this call, which can be found on our website in the same location. Reconciliation of non-GAAP financial measures to GAAP can also be found in the appendix of the accompanying presentation.

We wish to remind you that remarks made by management during this conference call and the supporting slide presentation may include forward-looking statements. Forward-looking statements reflect our views regarding future events and are typically associated with the use of words such as anticipate, target, expect, estimate, believe, assume, project, and should, or other similar words. We caution investors to not relay unduly on forward-looking statements. They imply risks and uncertainties and actual results may differ materially from expectations. We urge you to carefully consider the risks described in our filings with the SEC, which may be obtained on the SEC’s website at www.sec.gov. We do not undertake any obligation to update or correct forward-looking statements if later events prove them to be inaccurate.

I will now turn the call over to Tom.

Tom Siering

Thank you, July. Good morning and thank you for joining us today. Let’s begin with the summary of our fourth quarter and annual financial results, which can be found on slide three. Book value at December 31st was $10.11 per share, which represents a total return on book value of 0.7% for the fourth quarter and 0.5% for 2015. For the full year we realized a comprehensive loss of $4.5 million or $0.01 per share while generating core and GAAP earnings of $0.89 and $1.35 per share respectively.

In the fourth quarter, we realized a comprehensive loss of $3.2 million or $0.01 per share while generating core and GAAP earnings of $0.20 and $0.59 per share respectively. We repurchased 12.3 million shares in the fourth quarter at an average purchase price of $8.37 per share for aggregate cost of approximately $102.7 million. During the full year we repurchased 30.7 million shares at an average purchase price of $8.43 per share for an aggregate cost of approximately $115.2 million.

Subsequent to quarter-end, we have repurchased additional shares and announced that our Board authorized an additional 50 million shares for repurchase. We continue to evaluate share buybacks with consideration to a number of factors not the least of which is our prevailing share price relative to book value in the spectrum of investment alternatives.

Turning to slide four, 2015 was a successful year for our business. We sponsored southern securitization with the total UPB of approximately $2 billion attaining our goal of sponsoring 6 to 10 securitizations during the year, while also expanding our originator partner network. We added 6 MSR flow sellers achieving our goal of adding to 10 flow sellers in 2015 and closed on four bulk MSR acquisitions with the total UPB of $8.5 billion. Finally, the build out of our commercial real estate team was completed and we closed on 18 loans with the caring value of $661 million at December 31st.

Moving to slide five, from a macro perspective this was a challenging year. Interest rate volatility was elevated at the market weighted on the Fed’s decision to out raise interest rates, which finally occurred in December. Agency and credit asset spreads widened during the year. We expect future interest rate policy to be subject to both domestic and international economic considerations, but for right now lower for longer seems the most likely scenario as the U.S. is for the time being were up to any meaningful inflationary pressures. We strive to be a thought leader and remain engaged on regulatory and policy related topics that directly impact our business including credit risk transfer, the private label securities market and the role of private capital in the mortgage market.

Before I turn the call over to Brad for a review of our financial results, I would like to briefly comment on the FHFA’s final ruling on Federal Home Loan Bank membership, which now precludes captive insurers from ongoing membership eligibility. We are obviously disappointed with the FHFA’s final decision as we believe our interest aligned directly with the mission of the Home Loan Bank system and that our secured financings are consistent with their safety and soundness mantra. Since we were admitted as a member in 2013 prior to the proposed rulemaking we have a five year grace period on our membership. Therefore we do not believe the ruling will have an impact to our financing model in the near or intermediate term. Brad will discuss our financing profile with more granularity.

With that I will now turn the call over to Brad.

Brad Farrell

Thank you, Tom and good morning, everyone. Let’s turn to slide six. Book value ended the year at $10.11 per share versus $10.30 at September 30th and $11.10 at the beginning of 2015. We had a comprehensive loss of $3.2 million or $0.01 per share in the fourth quarter and $4.5 million or $0.01 per share for the full year.

Our comprehensive loss in the fourth-quarter was primarily driven by realized losses on both our agency and non-agency RMBS securities, partially offset by gains on our hedging instruments. The company also declared a dividend of $0.26 per share for the fourth quarter resulting in total dividends of $1.04 per share for the full year. Stock repurchase were accretive to book value by over $0.06 per share for the quarter and $0.07 per share for the year.

Next, I’d like to discuss our taxable income, dividend distributions and the 1099 treatments of those distributions. All of which are highlighted on slide seven. In 2015 the REIT generated taxable income of $404.8 million, which included taxable realized gains of $261.1 million on the sale of certain RMBS securities.

Since our 2015 dividend declarations of $376 million do not exceed taxable income. Our dividends will be treated as taxable to stockholders with 61.7% deemed long-term capital gains. Importantly we distributed 92.9% of our taxable income to meet our re-compliance. While carrying over $28.8 million of ordinary income into 2016. All these metrics aligned with our financial projections and tax planning efforts throughout 2015. For additional information regarding the distributions and their tax treatment reference the dividend information found in the Investor Relation section of our website.

Please turn to slide eight. Core earnings were $0.20 per share in the fourth quarter representing an annualized return on average equity of 7.8%. Core earnings for the full year were $0.89 per share, representing an annualized return on average equity of 8.2%. On the left hand side of the slide, we’ve provided a detailed quarter-over-quarter analysis of core earnings. I’d remind everyone that core earnings does not view by management as a key performance measure or dividend indicator. We focus on total return, which on occasion can reduce core earnings in the near-term as we protect our portfolio against book value of volatility.

Interest income decreased 12.6% quarter-over-quarter, primarily due to the reallocation of capital within our portfolio. Transitioning capital within our portfolio is not a linear process as it takes time to sell an asset, reinvest the funds and finance the new investment. While we have a team that ensures we execute that transition as efficiently as possible, the sizable shift of capital in the commercial real estate created a drag on core earnings.

Our swap cost decreased 35.3% during the fourth quarter due to a smaller average notional balance and lower swap rates. Resulting in less interest spread expense. Our other operating expense ratio for the quarter was 1.7% of average equity up modestly from 1.6% in the third quarter. The ratio increased as expenses were roughly flat. But stockholders equity declined due to the share repurchases. I will note however that we have added human and technological resources to support the conduit, MSR and commercial real estate. These factors combined with variable transaction expenses and the potential for further share repurchases may result in a higher expense ratio in 2016.

Please turn to slide nine for an overview of our financing profile. Our repurchase agreements totaled $5 billion at year-end down from $8 billion at September 30th due to sale of certain agency RMBS securities. Despite tighter balance sheet conditions on the street in the fourth quarter the repo market for RMBS continues to operate in a normal manner for us. As we leverage our counter party relationships and negotiate a reduced portfolio.

Our FHLB advances totaled $3.8 billion at year-end and we are pleased with the ongoing collateral shift as we onboard mortgage and commercial loans. Specifically we have $1.4 billion and $0.2 billion financing conduit assets and senior commercial loans respectively at year-end. I’d also like to comment on the FHFA’s ruling regarding FHLB membership. The final rule subjects us to a five year membership grace period and limits outstanding advances during this period to 40% of the assets of our captive insurer. It also prohibits new advances or renewals that mature beyond the five year period.

That being said we expect our existing advances maturing beyond the five year period will remained in place in accordance with their terms. While we are disappointed that our membership will end in five years. We are comfortable with the 40% asset requirement and as Tom noted, do not expect the ruling to have a near or intermediate term impact.

During the fourth quarter we also secured a $250 million repo facility for senior and mezzanine commercial real estate loans expanding and diversifying our financing capabilities. While it is FHLB repo or warehouse lending, it’s been a great deal of time managing our liquidity risk to counterparties, market and regulatory events. The optionality afforded by our financing tools allowed us to navigate these variables seamlessly. For more detail on our borrowings please see Appendix slide 26.

Next Bill will discuss the portfolio.

William Roth

Thanks, Brad. Let’s turn to Slide 10 to review our fourth quarter portfolio performance and yield. Our annualized net interest spread was 3.26% up 43 basis points from the third quarter. Net interest spread was positively impacted by the shift in our asset composition toward higher yielding assets, strong IO and MSR performance as well as solid yields across our credit and commercial real estate portfolios.

From a book value perspective agency spreads were mix throughout the quarter, credit spreads widened dramatically and swap spreads remain negative to treasuries. All-in-all these variables put negative pressure on book value. Due to the uncertainty in the market we believe it is prudent to continue to maintain low overall interest rate exposure and leverage.

Let’s turn to Slide 11 to discuss the composition and allocation of capital. As of December 31st the portfolio was $11.1 billion in assets with roughly 49% of capital allocated to the REIT strategy, 43% to the credit strategy and 8% to commercial real estate. Approximately 38% of our capital was dedicated to retained interest from our securitizations, our loan pipeline, MSR and commercial real estate assets up significantly from 22% at 2014 year-end.

Over the past year, we reduced the capital allocation to agency and non-agency RMBS from 78% to 62% as we sold RMBS with an amortized cost of $6.6 billion throughout the year. The transition of capital within our portfolio during 2015 was an exceptional accomplishment. We believe we have laid the foundation for higher risk adjusted returns for our stockholders overtime.

Now let’s turn to slide 12 and spend a moment on the conduit and MSR. We are excited about the development of our Agate Bay brand. According to our research Agate Bay was a leading issuer in the private label securities market, accounting for roughly 16% of the total new prime jumbo issuance in 2015. Investor interest in participation has been broad with over 50 different participants in October in inception many of whom have invested in multiple deals. Finally, deal execution improved during the year allowing us to generate attractive expected ROEs on the assets we retained.

Our conduit program is supported by high quality originator partners 44 of whom were active at year-end. The strength of these partnerships affords us the ability to maintain a solid pipeline, which includes loans and interest rate lock commitments of $1 billion at December 31st. During the fourth quarter we sponsored One Agate Bay securitization totaling $332.8 million and we completed our first securitization of 2016 in January totaling $299.3 million.

With regard to MSR we expanded our flow sale arrangements and added approximately $4.7 billion UPB by a bulk and slow purchases in the fourth quarter. Furthermore, yields on MSR remained attractive and we realized a gross yield of 7.2% in the quarter not including any hedging benefits. MSR continues to be an attractive asset for our portfolio and we were happy to be able to invest approximately $124 million in new MSR assets throughout 2015. Over the long-term we believe the success of our MSR platform will be driven by the organic expansion of our flow sale arrangements within our originator partner network and we are concentrating our resources on cultivating these relationships.

Please turn to slide 13. We deployed significant capital to the commercial real estate strategy during the fourth quarter as we added nine assets. This is a great finish to our remarkable year for our commercial real estate platform. At December 31st we had a total of 18 commercial real estate assets with a total carrying value of $661 million. These assets are secured by a diverse group of properties throughout the U.S. and have an average initial LTV of 72.3% and average spread over LIBOR of 507 basis points.

We plan on having a variety of financing capabilities to support this strategy including the $250 million facility Brad previously mentioned and the FHLB to finance senior loans. Opportunities in the commercial real estate market remain attractive and we expect to deploy additional capital to this business throughout 2016.

I will now turn the call back over to Tom.

Tom Siering

Thanks, Bill. Please turn to slide 14 and let’s discuss the future for Two Harbors. In 2016 we plan to continue to reallocate capital in sectors with more attractive returns including our mortgage loan conduit, MSR and commercial real estate. This will be accomplished by keeping our agency exposure low unless market conditions change and by selectively harvesting positions from our legacy non-agency portfolio.

We also constantly evaluate the economics of share repurchase. We believe the diversification of our portfolio will allow us to deliver high quality returns over the long-term while dampening volatility and minimizing risk. From a dividend perspective, we anticipate issuing a quarterly dividend of $0.23 per share in March subject to the discussion and approval of our Board. We expect this quarterly dividend amounted to be sustainable throughout the year.

As you know we do not typically provide guidance on dividends or other financial results. However, given extraordinary market conditions we feel it is beneficial this time to give stockholders more inside into what we are expecting for 2016. We do not expect necessarily to provide regular updates on our dividend outlook in future earning cycles. We are excited to build upon our accomplishments in 2016 and look forward to updating you over the coming quarters.

I will now turn the call over to Mitchell for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Doug Harter with Credit Suisse. Your line is open, please go ahead.

Tom Siering

Doug we certainly hope you are on a heater today but...

Doug Harter

No worries. I was hoping you could talk about the relative attractiveness of agency. Obviously you guys sold a lot of assets in the fourth quarter. Some of your competitors are talking about with lower for longer becoming more likely that this being an attractive time to add assets or we're take on little additional risk. Just want to hear your commentary on that.

William Roth

Yeah hey Doug it’s Bill. Thanks for joining us. Yeah, I mean look agencies have cheapened out somewhat and obviously that’s as you guys all remarking your comments hurts book value, but it’s good for future spread. However, given that we have so many different options to both deploy capital to agency is still sort of not at the top of our list. We still have in the like commercial MSR and development the conduit we still think those are better returns for our shareholders. The other thing is given we’re at such low rate in order to generate sort of in teens you would have to take some reasonable duration risk. And given where we are in the rate cycle it possibly stay lower for longer, but it’s a little dicey to be taking a bunch of rate risk when the tenure is at 185. So I’d say that yes it’s more interesting today than it was before, but probably does not crack our top two or three things to deploy capital to right now.

Doug Harter

Got it. And on the commercial real estate kind of given increased concerns around risk assets and health of the economy, how are you thinking about credit quality and where we are in that cycle and whether now it’s the right time to be adding those assets?

William Roth

Yeah sure. That’s another good question. So basically if you look at -- we look at each asset on an individual basis, we do substantial underwriting including LTV debt service coverage, et cetera. And while there has been a lot written about commercial real estate and particularly in some of the key markets whether it’s London or New York City or whatever, not all markets have experienced the run up that those have. And the way to protect to that against that is to make really high quality loans where the coverage is there and LTVs are low. So we are still very comfortable and the diligence that’s done on loans that we are making is extremely high there is it’s like anything else. It feel like you look at a lot of loans, but you only make a few of them. So…

Tom Siering

Yeah Dough it’s Tom. The commercial real estate, the risk embedded and it’s very idiosyncratic right? So the key is just really robust underwriting and we are committed to that.

Doug Harter

Great. Thank you.

Operator

Thank you. Our next question comes from the line Bose George with KBW. Your line is open. Please go ahead.

Bose George

Hey guys, good morning. Just first on the -- you talked about the drags from capital reallocation. I don’t know if there is a way to quantify that was there some sort of way to think about how much excess capital you carried while that transition was happening?

Brad Farrell

Yeah, I can take a response that. There is not a simple way to offer that for that calculation as you know investing and reinvesting throughout a quarter is quite complex and fluid. So to try to quantify the impact would be more estimate than actual math. But to give some color and maybe how you can model or think about it is in simple terms while accusive [ph] can settle T+2, T+3, we are going to be looking to sell those assets where there is an opportunity -- where the value is in the market. And so that could not -- that might not necessarily connect right what we want to on board a CRE asset. Meanwhile and we used to cure or lock CRE loan that can take anywhere between one to two months to negotiation and to due diligence as Tom mentioned.

And that settlement is very fluid so if you think about timing there can be call it two to four week windows where we have seen an opportunity to sell out of an agency or other type of asset where we’ve settled the CRE and then on the financing side our financing counterparties need to do their processes. And with the FHLB on that process can take anywhere between 20 to 30 days and with any other street counter party could also take a period of time. So maybe that’s hopefully a little high level to give you some thoughts on how that sequence plays out and we do everything we can do to kind of minimize that time line. But when you are redeploying that amount of capital there is impact.

Bose George

Okay, great. That’s very helpful. Thanks. And then just switching over to book value quarter-to-date, can you give us an update or just sort of puts and takes that we should think about?

Tom Siering

Sure Bose, it’s Tom. Thanks for the question. So it's inter quarter it’s our policy not to comment on book value unless so we think there is some move of significance one way or the other and those conditions don’t exist. So January was an extraordinary month I would say.

Bose George

Okay, great. Thanks actually just one more. Just wanted to confirm on the $2.3 billion of FHLB advances you guys have with the 20 year of maturity. So that states outstanding for those 20 years and you can substitute collateral as stuff rolls off over there.

Brad Farrell

Based on our understanding of the rule making and discussions we believe that that’s going to be out there for 20 years. At the same time just with all advances it’s all about collateral. It’s a pool of funding. So you can replace collateral as you see fit based on advance rates et cetera. So yes that’s a correct understanding.

Bose George

Okay, great. Thank you.

Operator

Thank you. And our next question comes from the line of Trevor Cranston from JMP Securities. Your line is open. Please go ahead.

Trevor Cranston

Hey, thanks. Good morning. First on the commercial real estate side, given the progress you guys made especially over the second half of 2015, have you guys really thought kind of the capital allocation target for that business or can you just give us some context on how are you thinking about that for 2016?

Tom Siering

Trevor this is Tom, specially good morning to you. Quite early there. So I would say that Bill and I and the investment team think about reallocation constantly, that’s what amongst other things what we are paid to do. So it’s certainly possible that allocation goes up. But it’s just going to depend upon as we go along what the investment alternatives are for us obviously we want to optimize return for shareholders. So it’s something what we constantly evaluate.

Trevor Cranston

Okay, that’s helpful. And then looking at the 2016 outlook slide one of the goals there it says is to broaden financing capabilities I was wondering if you could just expand on kind of the various ways you think you would be able to achieve that whether or not you guys have considered doing anything like potentially forming a broker dealer or anything like that?

Tom Siering

Sure. There is lot obviously going on with the Street from a regulatory and a capital standpoint. So we’re not really prepared to rollout any sort bold new alternative today. But it’s something that we are working very diligently on. If you look at our financing options today as Brad laid them out we have repo, we have warehouse line, we have the home loan bank I feel very good about where we are but it’s something you always got to constantly strive to reconsider because the world is changing constantly and the environment for the street is challenged. And so we continue to work on other options but today I don’t have anything definitive to say about but it’s something that we constantly work on.

Trevor Cranston

Okay, thank you. Appreciate the comments.

Operator

Thank you. And our next question comes from the line of Rick Shane with JMP. Your line is open. Please go ahead.

Rick Shane

Hi, I think I had my firm changed this morning. Anyway…

Tom Siering

Good morning, Rick.

Rick Shane

Good morning, guys. Trevor don’t worry I am still here you are still there. Anyway just wanted to ask a little bit about sort of the implications of the dividend for 2016. Implicitly you’re looking at about a 9% ROE based on where book value is. Given the transition in this strategy basically to what I would describe is an absolute return strategy going forward is that the right way to be looking at it, is it about 9% to 10% ROE or do you think there are going to be environments where you can do better and this is sort of a trough?

William Roth

Hey Rick good morning. This is Bill yeah I mean look, you know you followed this sector for a long time, if you look back number of years right we had expected ROEs on agencies and on non-agencies and a variety of things that were in the mid-teens or even potentially higher than that and that was just a function of spread that were available at that time.

So what we’ve seen in the last several years particularly as it relates to agencies with the Fed buying assets and compressing the spreads and also that filtering over into other asset categories is if there’s less spread then there’s less expected ROE and that’s just math there is no other way around it.

So if you look at what we’re trying to do in deploying the capital to what we think are the higher absolute as well as higher quality ROEs today what we’re seeing is the ones that are the most interesting to us are sort of low double-digits and low maybe potentially mid double-digits. So when you take that and you knock-off the cost of operating our business it gets into that as you call it 9%.

Frankly if you’re not taking a lot of risks and you are not taking a lot of interstate risk et cetera that’s sort of the way the math works and that doesn’t mean that going forward the spreads won’t be more attractive I will say this one thing that we’ve seen going on in the market lately particularly if you look at CMBS and high yield and other sectors our spreads are starting to widen up quite a bit. So it could very well be the case that this is trough but that will really depend on what spreads are available going forward. Our goal is to drive the best risk adjusted return while protecting book value that’s what we try to do over the last six years and what we’ll try and do going forward.

Tom Siering

So Rick obviously the easiest way for us to move the needle is through the agency space right. I mean that’s without question and agency spreads while they are more attractive than they were a bit ago still by historic standards aren’t anything to shout about. To the extent Bill and I remain convinced that there will be a sunnier day in the agency market and that’s why we are maintaining a low risk profile in the agency space and planning for that sunnier day. It may never develop, but at this point the risk reward we think is certainly has tilted towards keeping spread duration lower, keeping risk low and that’s why we’ve positioned the portfolio.

Rick Shane

Got it, that’s helpful. Thank you. And to follow-up on that just a little bit you guys point out the drag this quarter from the transition of the portfolio and I assume that overtime the whole opportunity here is to reallocate capital is it fair to say that this was the quarter where it was more of a I guess structural change in the portfolio and then going forward you would expect more sort of incremental that if you see opportunity for example in agency land it will be more about taking leverage up or down there and that we wouldn’t really necessarily expect to see that type of drag going forward?

Tom Siering

So in respect to the drag for the quarter I would certainly say that to try to quantify that would be perhaps challenging and maybe a tickle this in genius because it’s frankly is more art than it would be science but without a doubt there was a drag from our reallocation capital. So if you look at it was a bit of a transition period in respect to the commercial real estate effort because we are on 40 month of federal home loan bank which was something somewhat new and also we obtain this warehouse financing facility. So I would say in respect to the financing of commercial real estate it was a period of transition and without a doubt it created drag on the core earnings for the fourth quarter.

Rick Shane

Thank you, guys.

Operator

Thank you. And our next question comes from the line of Ken Bruce Bank of America/Merrill Lynch. Your line is open, please go ahead.

Ken Bruce

Thanks, good morning. It seems like we’ve got all the San Francisco analyst on at the same time. My first question really is kind of directed towards the reallocation or just the change in the portfolio mix I mean there is clearly some concerns around the state of the U.S. specially if you look at the equity market and I guess I would to know how you are thinking about the continuation of acquiring credit asset if there is a probability of going into a recession and maybe you don’t believe that but if you could maybe comment on some of the discussion around inverted curves in the implications for the portfolio that would helpful? Thank you.

Tom Siering

So you guys all gathered in a coffee shop somewhere and you just passing the…

Ken Bruce

We could but unfortunately we’re not.

William Roth

So Ken I think I heard two questions in there. So the first one was around the credit asset, first of all as you can see our residential credit continues to decline commercial credit is obviously in the grand scheme of things d small part of our book but we are seeing really good opportunity there to make -- to basically to make loans at what we believe to be at very solid LTVs and coverages. So Tom said it’s idiosyncratic, there is commercial real estate section is huge and certainly there is like I said before there has been some run up in say premier properties in New York but if you look in our disclosure at the back you are going to see sort of generally smaller to mid-size loans. And so we are actually very comfortable with that. On the residential credit we continue to sell that’s declined because we’ve selling those assets. Could there be a point at which we start to get nervous on the commercial side I guess but we are not anywhere near that at this point.

The second part of your question you referred to an inverted curve, so could you just elaborate on that a bit so I can try and answer the question appropriately.

Ken Bruce

Sure. I am not a rate [ph] expert by any measure but at least some of the folks at our shops that are kind of looking kind of the current yield curve and some of the issues around it shape relative to a zero bound and are suggesting that it’s actually quite a bit flatter than the nominal curve suggest and the implication there is that it’s a precursor to a recession. So I guess really I'm interested in terms of not only how you think the credit assets perform to the degree that that relationship stands, but also how the portfolio as a whole is positioned in fact you get more of a flattener or an inversion going forward?

William Roth

Sure well so there is a bunch of things in there. So I would say first of all while our residential credit book has been declining due to sales, I’d also note it’s certainly still a big part of the portfolio to the extent you get, I mean in recession certainly you would expect to see home owners potentially some of them anyway having trouble. But if you look at what we have right the composition is the bulk of the legacy that we have, those loans are typically on average maybe 10 years of old and if you look at gas prices the amount of money that’s flowing through to the pockets of home owners is much higher because they’re spending less on gasoline.

So actually lower gas prices, lower rates actually benefits residential borrowers. And then the conduit assets if you look at those and you look at the average LTVs on the Agate Bay deal I mean those are ludicrously low and I’m not saying we won’t have any delinquencies there, but so far we don’t have a single loan 60 days. And so well we have had, but we don’t have any currently. And so basically if you look at that we think the credit quality there is extremely high.

So I mean look we just have to keep our eyes on and see how things play out, but we’re very comfortable with our exposures there. In terms of that curve I mean look we’re at very low rates, the Fed raise rates maybe they’re down in the market sort of indicated that they might be done for the year in terms of the re-pricing in the frontend. Look we could have a situation where the coverage is extremely flat at low interest rate levels and that will produce its own challenges from our standpoint in the agency side where you’d expect to see very fast prepaid, the bulk of what we still have is still highly prepaid protected. There’s a bunch of information on that in the Appendix.

Our prepaid speeds are still very low and typically we do or not as you know today or historically incline to take a lot of interest rate risk and curve exposure. And so as a result we think that if we get into that situation from a rate and curve standpoint that we will be in reasonable shape.

Ken Bruce

Right, thank you. From my own perspective on that… sorry?

William Roth

I was going to say that's a mouth full but I hope I...

Ken Bruce

Yeah I mean it was somewhat academic question so I apologize for that, but there is quite a bit of concern as to and singling out the market as to what may be coming through within the U.S. economy you can point to a lot of different things that maybe cause all of that, but anyway we’re just trying to understand how what the implications are for the portfolio and I guess we’ll just have to kind of stay tuned to how things going to shape up. Maybe just lastly this kind a gets into a little bit of a broader discussion around some of the strategic direction of the company whether you look at it from a CRE point of you whether you look at it from the conduit point of view. A lot of these businesses are obviously operating businesses and I’m wondering if you think that there is a particular competitive advantage that you have in any one of them or how should we really think about if you will the value generation within those businesses. It’s independent of obviously kind of what the investments by product is that you hold in the portfolio. Thank you.

Tom Siering

Sure this is Tom I’ll tackle that one. With respect to your question about the curve, if I could just say a few things about that. The investment team does a really remarkable job of hedging spots along the curve. And as the interest rate curve moves around that’s really critical to the existing book. Now obviously as it inverse that creates challenges for future allocation to that space. But the critical thing is as a curve moves around it’s not just kind of hedge your interest rate exposure. It’s pristinely hedge exposure along the interest rate curve, so just to make that point.

And secondly with respect to our competitive advantage, if you look at what we think that it how exist within the MSR and the conduit business it’s by providing capital solution to our originator partners and then working very effectively to onboard MSR and prime jumbo. And so we’re dedicated to being best-in-class in respect of our interaction with our counterparties working efficiently and constructively with our originator partner. And we really do think that’s a competitive advantage.

Obviously both of those markets are competitive, but on the margin, being a preferred counterparty definitely has the advantage and it gives us edge. In respect to commercial real estate we think our edge is this that we have hired a cracker jack team with many, many years of experience it was through a number of cycles. And then in respect to financing I think we’ve done a really good job in that space. So obviously we can use the home loan bank we have a warehouse facility. But I really think our competitive advantage there is our team. And we’re quite excited about that opportunity.

Ken Bruce

Okay, thank you very much. Appreciated.

Operator

Thank you. And our next question comes from the line of Brock Vandervliet with Nomura Securities. Your line is open, please go ahead.

Brock Vandervliet

Thank you, good morning. I guess questions for Bill in terms of the MSR investments that you’re pursuing, I mean, the world has changed so radically. I think we’re about 35 basis points lower on the tenure year versus mid-December. How do you look at this as such a profoundly rate sensitive asset do you lean into it. And build that portfolio more or are you more likely to hang back and built it more slowly at this point?

William Roth

Hey, Brock good morning. Yeah that’s a great question. I mean look MSR is terrific asset for our portfolio right. It has negative duration, and yes it can volatile, but we have the same volatility with any other hedge if you had swap if rates fall you’re going to lose on swap. So it’s another hedging tool. It also throws off an attractive yield certainly compared to the negative spread you have on swap. And lastly it hedges the mortgage bases. So to the extent the mortgage is widen versus swap, MSR looks at the mortgage rate in terms of its price not the swap rate. So it’s really an ideal asset for us.

In terms of our plan to continue doing what we are doing and in fact you could argue that as rates have been moved lower it’s actually a better time because at some point if rates continue to go lower the MSR requirement is more likely to stay outstanding for much longer. So we haven’t really changed our plans. We are still looking at bulk packages, as you know we pick some up in the fourth-quarter -- number of times last year. We are continuing to work on adding flow sellers where you basically providing daily liquidity to originate a partner. So we have no -- the rate environment hasn't really changed our outlook. The prices are still attractive and we are still interested in adding.

Tom Siering

Also hedging with interest rate swaps, hedging on mortgage portfolio with interest rate swaps always has its challenges in respect of not only the bases, but also complexity [ph] because obviously interest rate swap has a defined duration where a mortgage is dynamic and its duration profile. And so interest rates -- hedging today with interest rate swap is particularly challenging because there has been some dislocation versus historic relation between that and treasuries and mortgages and therefore MSR from a basis standpoint and from convexity standpoint are certainly as attractive as they’ve ever been. That being said obviously we are price sensitive and we want volume MSR at any price, but at the prevailing prices. We continue to be quite interested in them.

Brock Vandervliet

Just as a follow-up to that comment, is there anything you are doing differently with respect to hedging and hedging strategy given the tightening of swaps rates?

William Roth

It’s something that we continuously evaluate. But adding MSR at an attractive price makes more sense than ever. I will certainly say that, given the challenges that exist within interest rates swap markets today. But it’s something that like anything else we want to be married to a particular hedging strategy. It just depends on the prevailing prices for swaps, for swaptions, for IOs, for MSR and something that we constantly reshuffle depend upon market prices.

Brock Vandervliet

Okay, thank you.

Operator

Thank you. Our next question comes from the line of Joel Houck with Wells Fargo. Your line is open. Please go ahead.

Joel Houck

Thanks and good morning, guys. So a lot of the technical questions have been asked. Let me maybe shift gears and ask more of a theoretical question and how you guys think about the macro and the rate environment. Today five year rates are negative in Germany, Switzerland and Japan and obviously that’s not the case in the U.S. and in UK. But it seems to me like the risk of a recession and also Ken pointed out a flatten or even inverted curve heaven forbid we see negative rates in U.S. But how do you handicap that the fact that the increasingly it seems like the U.S. is not going to decouple from the rest of the world.

And how does the allocation of capital at all change if for example you are sitting here a year from now and 10 years at 125, I think because I ask that question I need the prevailing sentiment and it’s not just too hard with I think gets analyst the investment community is that rates are low and eventually they will go up. But the flip side to that is we could be in a long-long period of time where we just head toward where Germany, Switzerland and Japan are already at.

William Roth

Hey Joel it’s Bill. Thank you. Yeah, I mean look that’s certainly a non-zero possibility, right. As you mentioned many mainline economies have zero or negative rates. I think it clearly depend on the growth outlook and not just how the U.S. does, but how the rest of world does. I mean look we talked about this all the time in terms of protecting our book value against whether it’s I think it was only a year ago everybody is concerned about super high rising rate and now it seems like every question is related to rates going lower and the curve flatter.

So this is the stuff we talked about all the time. We think about protecting our book value in either of those scenarios. And in terms of what that will mean for asset spreads or potential returns going forward that remains to be seen. I think as I’ve said couple of times on this call, while we do have a significant amount of portfolio that has credit exposure. If you look at the retained interest from Agate Bay the average LTVs on those are in the 60s, FICOs are in I don’t have it exactly in front of me, but extremely high FICOs those are pristine prime jumbo loans.

The legacy non-agencies these are guys that are still in the pool, but in their house 10 years or so. So very seasoned loans and as I talked a couple of times about the credit the commercial portfolio. So look I don't know that environment would bring certainly on the agency side we would expect it to bring extremely high prepayments, which would be associated with the much lower mortgage rate. And so that’s something that Tom alluded to we’re keeping fairly low because from a historical basis and if you look at the price of agency MBS it’s not super attractive to us now, but it could in the future. So I think our primary thing if you look at our leverage its low. Our general exposures are low and we’re trying to be very protective as we transition capital.

Brad Farrell

And as I said earlier, I mean the key is right to hedge exposure along the curve and there is not zero probably of U.S. rates move lower still. And so the gain of mortgage book is not localized moves it's shocks one way or the other like and the key there is to hedge curve exposure appropriately and also build optionality into the interest rate hedging profile. And that’s something we constantly review and tweak depending upon what options we have in respect to hedging interest rate exposure. But it’s something that we work on constantly and I think we feel very comfortable where we are today.

Joel Houck

Yeah I think I mean, I appreciate the color I mean, I think people aren’t necessarily think about I think people think you guys do a good job at hedging those shock type of events. I guess I was more going toward if we’re in an environment like that where I think you pointed out even agency returns may not the whole curve compresses. You just in a really low ROE environment. Is that how do you think I guess the second part of the question is how do you think about share buyback in another words if this were persisted for a long-long time. Is there, I assume there is a capacity to increase the buybacks, but how would you look at that versus continuing to own or reinvest to keep your balance sheet constant in a lower compressed ROE environment? I guess the question is there is a point where ROE is so low that it’s just make sense to buyback the max amount of stock you can in a given quarter or year.

Tom Siering

Yeah sure. With respect to reinvestment, obviously our prepayments speeds are quite low. So we have less reinvestment to do than a typical mortgage REIT, I will make that point firstly. Secondly, we’ve shown a commitment to repurchasing shares obviously we bought over 3% of our outstanding shares in the fourth quarter. And so yes if ROEs stink and our shares are depressed relative to book value we are committed repurchasing shares. I’m not going get into a discussion about the maximum number of shares and so forth, but obviously we’ve shown a dedication to that. We previously socialized on this call, but we continue to buy shares in this quarter. And we will continue to do that if ROEs are depressed and our share prices are cheap relative to book value.

Joel Houck

Alright great. Thanks for the color.

Tom Siering

Thank you.

Operator

Thank you. And I'm showing no further questions at this time. And I would like to turn the conference back over to President and CEO Mr. Tom Siering for any closing remarks.

Tom Siering

Thank you, Mitchell. Thank you for joining our fourth quarter conference call today. We will be attending the Credit Suisse Financial Service Forum in Miami, Florida on February 9th. We would welcome the opportunity to speak with you at this event. Have a wonderful day. Thank you.

Operator

Ladies and gentlemen thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.

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