Hatteras Financial Corp (NYSE:HTS)
Q4 2015 Earnings Conference Call
February 17, 2016, 10:00 ET
Mark Collinson - Compass Investor Relations, Partner
Michael Hough - Chairman & CEO
Mike Buttner - Chief Risk Officer
Ben Hough - President & COO
Ken Steele - CFO
Fred Boos - Chief Investment Officer
Douglas Harter - Credit Suisse
Joel Houck - Wells Fargo Securities
Bose George - KBW
Steve DeLaney - JMP Securities
Brock Vandervliet - Nomura Securities International
Welcome to the Hatteras Q4 2015 Earnings Conference Call and Webcast. [Operator Instructions]. I would now like to turn the conference call over to Mr. Mark Collinson, Partner, Compass Investor Relations. Mr. Collinson, the floor is yours, Sir.
Thank you very much. Good morning, everyone. Welcome to the Hatteras fourth quarter 2015 earnings conference call. Please note, for those of you who would like to do so, you may download a supplementary information pack to accompany this call from our website at www.hatfin.com. Go to the news and presentations tab at the top of the page, click on presentations from the drop-down menu and then click on the link for Q4 supplementary financial information.
With me today on the call, 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 Chief Investment Officer, Fred Boos and Chief Risk Officer, Mike Buttner.
Briefly before I hand the call over to them, I need to remind you all that any forward-looking statements made during today's call are subject to risks and uncertainties which are discussed at length in our annual and quarterly SEC filings. Actual events and results can differ materially from these forward-looking statements.
And the content of this conference call also contains time sensitive information that is accurate only as of today, February 17, 2016 and the Company undertakes no obligations to make any revisions to these statements or to update these statements to reflect events or circumstances occurring after this conference call.
That's all for me. Here's Michael Hough.
Good morning and thank you all very much for joining our call today. After prepared remarks, the team is here to answer any questions you may have. And as Mark alluded to, please refer to the supplement presentation for more information. It's been an interesting four months since our last call and we'd like to get you caught up on our thoughts around our business.
Without opining on our view of rates, we accept that the yield curve is flatter than any of us hoped for and rates could stay lower for longer than anyone expects. These conditions certainly challenge all financial institutions and require concentrated efforts to manage directional risks and may even require adjustments in strategy to adopt to changes in outlook. But they also provide opportunities that can put a company onto stronger footing.
As we've discussed on prior calls, our efforts are focused on being able to deliver attractive risk-adjusted returns through cycles while at the same time being prepared for higher interest rates, especially considering where rates are today.
So first off, I'd like to start with our stock price and repurchase opportunity. We're currently trading at a14% dividend yield and at a 30% plus percent discount to the market value of our highly liquid assets and liabilities. We operate in some of the deepest and most liquid markets in the world that are constantly moving to reflect market expectations for the future. From both a short and long term perspective, we see nothing in the markets that justify these types of valuations in Hatteras or the mortgage rate industry as a whole.
Last year, we developed new infrastructure and capabilities that should add a lot of value to our franchise going forward. With the Pingora acquisition completed and integration nearly done, we now have clearer visibility on the related capital and liquidity needs and can be more deliberate in our capital allocation. Buying our stock back is a compelling investment today so we expect to allocate a significant amount of capital there while the opportunity exists.
We bought back about 2.4% of our shares in December and January and going forward, as long as valuations stay depressed at significant discounts to current book value, it makes sense for us to allocate cash flow to repurchase stock. This quarter we're earmarking $30 million to $40 million out of cash flow to repurchase shares. We have plenty of liquidity and a solid risk template to be able to achieve ongoing repurchases going forward. As we've always had, the accretion we get from buying back stock at large discounts is one of our tools in the creation of long term value and we're committed to it when the market gives us the opportunity.
So moving on to the business, over the last two years, we've been working to enhance our platform and success of the effort just started to deliver in Q4. As of December 31, we had over 20% of our capital allocated outside our traditional ARM focused agency MBS strategy. And effectively even more when you consider that some longer duration MBS has been allocated to balance our MSR portfolio.
In our world of residential mortgage finance, we've adjusted from a pure hedged agency MBS portfolio to one that includes mortgage servicing of residential credit. Each has its place and how we allocate will depend on available market opportunities and risks.
As you know, we like the servicing asset for the portfolio. In this environment, new MSRs provide a nice return and the negative duration provides a good offset to the positive duration of the agencies. They also give us enough negative duration to comfortably add more fixed rate assets without meaningfully adding to net duration exposures.
We see servicing as an excellent asset to acquire, especially now with ultra-low rates and we have our sub, Pingora Loan Servicing, who has a best-in-class ability to access and manage them. Pingora has an efficient variable cost model where the business can be done effectively without bearing the large fixed cost of an originator or straight servicer. MSRs are a tricky and sometimes volatile asset, so you have to know what you own, how they fit in the portfolio and how to manage the counter parties and regulatory issues which is why we opted for acquiring the infrastructure and expertise of Pingora and not trying to build it out ourselves.
By combining with our mortgage expertise, we believe the Hatteras/Pingora synergies have a number of significant advantages relative to our competitors, including we can buy 100% of our MSRs on a flow basis from over 60 originators who sell to us because we're consistent with a best-in-class operational platform that by all accounts makes doing business with us easy. Our top-tier technology platform enhances risk management and servicing oversight and helps us create pricing power.
In our flow program, we have the discretion to select only those assets and counter parties that meet our high standards relating to price and risk criteria. We don't need to rely on big bulk purchases to acquire the asset which typically are priced at significantly lower returns than flow. And we don't own legacy MSRs, an asset that has an entirely different risk return profile, especially in this aggressive regulatory environment.
In the past, we've indicated we're comfortable with allocating a meaningful amount of our capital to MSRs and that has not changed. The top of the $259 million we onboarded in 2015, we acquired $25 million in January but future volume will probably very largely in line with industry production levels. We price MSR flow to a low double-digit IRR, but of course, the return ultimately will depend on when they were initiated and on the direction of rates.
Gross returns were a bit higher than that in Q4 as we acquired new production and keep in mind these returns will normalized a bit as the portfolio seasons. One additional thing to mention, despite the significant recent rate move, we believe that less than 50% of our servicing portfolio is at significant risk of refinance. And we have agreements in place with strong partners to help us recapture servicing that might otherwise refi away.
Pingora has a recapture rate in excess of 15% so far this year and we expect those numbers to improve over time. So on jumbos at our PRS, Onslow Bay, the proprietary flat platform that we built over the past couple of years will be highly valuable to us going forward. And in December we completed our first securitization. We're pleased with the high credit quality of the jumbo ARMs in the deal and its recognition by the rating agencies.
As planned, we retained all subordinate tranches in most of the AAA securities. However, new commitments for the purchase of jumbo ARMs have fallen significantly over the past few months. Part of the drop is normal seasonality, but much of it is due to the flattening yield curve which has made ARMs a smaller part of the market.
We remain steadfast in our return targets and credit standards and will not raise prices or lower the credit box in order to chase higher mortgage volume, that makes no sense. To lower volume means a longer period until we could complete our next securitization and get the leverage we desire.
Since the FHFA's final rule on home loan bank membership, we lost a potential attractive funding source for now, so we will likely use relatively expensive warehouse financing for our whole loans. Also in this period of low jumbo ARM supply, bank balance sheets continue to portfolio what they originate and suck supply from the market. So until the yield curve steepens and conditions improve, we will look for ways to opportunistically use the platform or release some capital for alternatives, although at times we may pursue other credit investments that could arise.
Finally, before opening up for questions, I'd like to reiterate why the strategy adjustment is superior to our traditional levered-only agency strategy and why we think it will produce better risk adjusted returns over time. We expected that we can generate comparable to higher returns of the long term with less volatility in multiple ways. We will have less concentration in both our assets and liabilities. We will utilize less leverage. We will operate with less basis mismatch risk. We will reduce sensitivity to the shape of the yield curve and most importantly, we have greater flexibility to adjust the market conditions.
All in we have a stronger and better Company. Although we expect this asset mix to mitigate some of the volatility over time, our core business remains that of managing a levered fixed income portfolio. We continue to view the risk of rising interest rates as our primary concern and our commitment to minimal duration exposure, especially with the sub 2% 10 year is the right way to manage the business.
Even if it creates near term challenges to manage through if rates remain low. The ongoing adjustments to our portfolio and our hedge book reflect our ongoing responses to changing economic conditions, risk tolerances and market opportunities. And that's a process that we're dedicated to each and every day.
So with that, operator, we can open up to any questions.
[Operator Instructions]. The first question we have comes from Douglas Harter of Credit Suisse. Please go ahead.
Can you just talk about how you see the relative returns across the three major investments? You've made to date and more particular whether you see MSRs or the levered agency as being more attractive today?
The way we look at the MSR business, it continues to be low double-digit return for us. If you're three business line. Then if you're looking at jumbos, we're still looking at were we able to securitize and fully leverage the asset that's probably a high single-digit return overall. And from an agency standpoint, we still look at that as being a high single-digit also return overall.
And obviously, I guess your focus has been and Pingora's focus, has been the flow. Do you see opportunities to acquire bulk MSRs with those higher returns?
Typically, the bulk transitions are more competitive and trade at lower internal rate of returns. Our focus is to stay with the flow program where we have steady volumes coming from customers who we work with and we think we can get that asset at a much better return than trying to compete out in the market. And the amount of production that were getting through that process is sufficient to meet our needs.
And then just one more on the MSRs. Has that having an MSR portfolio and one with growth, has that changed the way you've constructed your hedge portfolio?
Yes. Part of the reason of adding the MSR is to allow us to have less reliance on euro dollars and swaps. So it's not a wholesale change, but over time, you will see that exposure will decline.
I want to make a quick point. We look at this as a way to allocate portions of our capital and especially now with ultra-low rates and maybe mortgage rates potentially at all-time lows, who knows? It's a very good time for us to add to the asset and to allocate capital. So, the timing of the business we think is spot on and we continue to believe that allocating and adding MSRs through flow will be advantageous to us as the fiscal low rate environment persists.
Next we have Joel Houck of Wells Fargo.
So, question around the sizing of the MSR holdings. What, in an ideal world, relative, taking into consideration that it's a better hedge than swaps euro dollar futures, what does the size of that MSR look like optimally in terms of relative to the ARM portfolio?
We addressed this a little bit last quarter. Looking at our portfolio today, we've allocated approximately 20% of our capital. I think that's the right amount of MSRs for the other assets that we have. If you look at that on our $15 billion portfolio, that could be $400 million to $500 million in MSRs.
But a lot of that's going to depend on what happens with interest rates. I think we can envision the possibility if interest rates go lower for whatever reason from here, that it might make sense to increase that allocation from there. But right now, based on the portfolio we have today, we think that's the appropriate place to be.
Okay. So, in addition to a hedge, it sounds a little bit like there is an alpha generation strategy in the sense that if MSRs are attractive at certain rate levels you would increase that allocation. Can we take that to mean that at higher rates, you might pair that back some?
I think we have to look at the market opportunity whichever direction it goes. In my view, if you have, if the optimal part to put MSR on is when the mortgage rates is at it's all low and if that's the case, then, yes, that would be right. But we will have to look at what the market opportunities are at any given point time.
And in a flow business too, part of what we have on is what our desire may be, but also what production is. So, just in a higher rate environment, production will be slower and conversely it should be higher in a lower rate environment.
Okay. And then last question is just do you have any color or commentary on prepayment speed this year given we saw a major obviously a rally in the 10-year, but not necessarily mortgage rates this year. How do prepays look year-to-date so far?
A - Ben Hough
ARMs lagged a little bit in slowing down late last year and fourth quarter, they were average 17 compared to 21, I think, in the third quarter. So, they gradually slowed down, but they kind of caught up here in January and February. We had a 16.7 print in January and a 13.1 print in February.
So a pretty healthy slow down there. A lot of that's seasonal, but also reflected some of the higher rates late last year. As we put in our supplement, we expect them to pick up given the flatter yield curve and the overall lower rates going forward here probably in the second quarter and third. It just all depends on the rate environment, of course.
Next we have Bose George of KBW.
Just to clarify on the low double-digit return you mentioned on the MRS, does that include any of the benefit of potentially having less hedging going forward?
No. That does not. Those are ours Rs that we -- and that's how we price the security on a daily basis. There is a hedge benefit as they replace swaps or EDS at the curve, then there will be an additional benefit to that from an earnings perspective.
And is there a way to quantify that? Is it a couple of points?
Well, it's just going to depend on how the portfolio changes as the MSR grows. But if you look at a swap at 1.5% that we may not have to put on because we have this negative direction with the MSRs, you could add 1.5% to that, whatever the degree is. But they are ratios and to think about it, it does perform a hedge for us because it's negative duration but it's an earning asset as well. It's just a diversified asset that provides us negative duration just like our hedges do.
And then just switching to the performance of ARM MBS this quarter, can you just give us some color on that versus fixed and just see it generally quarter-to-date, any book value color would be great.
We saw price changes mostly in the ARMs book, we're mostly in the shorter reset in season paper. As rates rose and the shorter on the curve you were, the asset was, the more it was impacted and so our more seasoned, shorter reset paper underperformed the longer hybrid ARMs and the fixed book. Most of the book value pressure on the agency MBS side was from the seasoned ARMs book, of which we have quite a bit. That's where the price erosion was. It wasn't significant but for what there was, that's where the pressure fell.
Those speeds counting in in the low 20s and historically, they've been around the mid-teens. That sector of our ARM portfolio is a bit faster so therefore the prices are reflected in that.
And then actually just switching to GFC risk sharing. Are there opportunities there for you guys going forward?
Yes. We do own a small position in [indiscernible] coupons. With the volatility that we've had and over the last few months, those spreads have widened out significantly. We're looking at them to see if that should be a little more of a capital allocation but we have to look at that in context of everything that we're doing.
Steve Delaney, JMP Securities.
I was wondering if you could offer just some brief comments on how you're seeing current conditions in the repo market and the depth of that market? And then longer term, Michael, any thoughts you have about the outlook for possibly regaining federal home loan banking membership in the future would be helpful. Thanks.
Well funding in the repo market remains liquid and it's readily available. One-month agency is currently around mid-60s, 65-ish and that's up from about 40 beeps prior to the fed move in December. So, maybe a little bit of pressure in the 30-day but we track to liable or so.
Historically, we've been paying about 20 beeps over comparable LIBOR and that puts it around low-60s to mid-60s. But to answer your question, the funding is available. We've had no issues. We have no exposure, membership exposure to the home loan bank system and we don't view the prohibition of any captive insurance subs as problematic to repo as well--
How many active counter parties do you have now for your repo?
We have about 40 in total signed mortgage repo agreements and, actively, about 30 I guess are pretty active, maybe low 30s.
So, that is something that has not been a concern today. Everyone's lending was up. We have excess capacity at most of our counter parties and we're comfortable there. And Fred did make the point that we didn't have, we weren't using anything at the Home Loan Bank of Atlanta to speak of at the time so that was not an issue for us.
But it is disappointing to not have that today which is something that I think more on the Onslow Bay side, on the loan side, is where we could really have taken advantage of that and gotten significant benefit, but for now, we know that's not an option. Long term, there are various avenues of attack, I guess that's not the right word, but of approach to try to get this moving forward and to have it come back to us either in the form of captive insurers or potentially even mortgage rate membership.
And I think it's probably going to end up on the legislative side going forward. This is going to be a tough year to get anything done, but it is an active conversation and I think we have the right people on our side in Congress helping us push it. And so, we will continue to hope and expect at some point that will be an option for us again.
The next question we have comes from Brock Vandervliet of Nomura Securities. Please go ahead.
Most of them have been asked and answered at this point. I did want to ask about dollar roll and the balances as continue come down. I guess we'd all been expecting that to gradually trend down as it has. It seems like, given the turmoil and uncertainty, that potentially there could be a longer period of reinvestment. What are your thoughts on specialness in the roll? Thanks.
The rolls have still stayed attractive when you compare that to repo funding. They're not nearly as attractive as we saw when the curve was at its steepest. And, when you have movements like we just did and kind of a bowl flattening, drops do come off a little bit. So, we've maintained our exposure in 15-years and what happened also, we added 30-years and we move them from pools into TBA this quarter.
So what you'll see is from the dollar roll perspective, we have increased, though we've moved from pools to TBA in the 30-year piece and are rolling that. So, typically going into year end, with balance sheet constraints across the board, your rolls are not extremely strong, but they have come back.
And separately, just following up on Bose's question. Any comment on book value, quarter-to-date?
Well, we typically don't do that as it's such a moving target on a daily basis, but I think if you look at the market as a whole and since year end, we have seen some tightening in swap spreads and we have seen some widening in MBS spreads even though the rates have rallied. So I would think that you could look at that to see that there is some pressure on book value since year end as of today.
Okay. And just another crack at the MSR impact, I understand that helps you hedge the portfolio but I'm not clear on whether the earnings from the MSR is hedged itself. Maybe I'm not asking the, thinking about that correctly, but what I'm trying to get at is whether this increase is somewhat earnings volatility that we should be aware of. Thanks.
Yes. I think that's a really good question. As it does, we look at an overall what net duration exposure of the portfolio to various changes in shape of the yield curve. And MSRs have their own characteristics and their own negative duration that will serve to offset some of the negative duration that we carry on the hedge book over time, especially as it grows.
But it also provides, it also has negative duration that we feel like we need to offset with longer duration assets at times. So, most of the MSRs that we have are based off of 30-year mortgages and have adding 30-year to the portfolio which we have never done, but it makes sense for us to do now because it's a better match for parts of the duration strip that we have on MSRs. Does that make sense? So we're going to have both. It's going to improve the hedge book, but it's also going to be an asset that we will add, help balance the overall risk.
[Operator Instructions]. Next we have Ken Bruce, Bank of America Merrill Lynch.
This is Sean on for Ken. Thank you for taking the question. Let me just start with a quick technical one. The net gain on MSR of $11.2 million, does that include the $2.3 million of valuation change or is that just sale of the MSR? What exactly is going on to that number?
Please repeat the question, Sean. I'm sorry.
Maybe my phone was having a little difficulty this morning. The $11.2 million and other income net gain on mortgage servicing rights, does that include the $2.3 million of fair value change or is that just a sale number?
That's just the value change itself.
Okay. So, just out of curiosity, where is the $2.3 million? Is that flowing through a particular line item in other income or is that actually in a servicing income number?
What's the $2.3 million? Where's the $2.3 million from?
The $2.3 million, if you look at the footnote, is the reduced by the amortization of the MSR asset and core earnings.
Yes, it's in that number. It's in the $11 million.
So it is in the $11.2 million?
And then more of a broader question that was kind of addressed earlier, you guys are seemingly preparing for higher rates and would add MSR assets as rates declined. Have you thought about a scenario where perhaps rates are lower for longer, the forward curve is anticipating only one more tightening over the next several years and 10-year is staying very low compared to what people though the outset of this year and even last year. Have you given any thought to that? Is that not really factored into your strategy? Going to keep on adding MSRs and jumbo ARM as you see fit? Or just your thoughts around that.
Yes. We've absolutely thought of that and you have to think of that because that seems to be market consensus to a degree right now. So it is, everything we do here is based on evaluating and trying to mitigate risk from changes in the market. And there are definitely risks that come from lower rates for longer and -- but as we've always said, since the day we started this Company, that we believe that the greatest risks to a levered fixed income business is higher interest rates.
And that is something that we will always be defensive of. And it's something that any financial institution that invests in these securities would be very remiss in not being defensive against. So that has not changed. What has changed is how we're achieving that. And yes, we added MSRs which is going to be an asset that does well when interest rates go higher.
But it's also an asset that we feel like is one that now is an attractive time to add to the portfolio. So, that's not going to change. We do believe the long term greatest risks to this business are rising rates and we'll always be defensive against it. But that doesn't mean that we're not taking steps and we're not analyzing the risk associated with lower interest rates.
Part of the scenarios that we run when we look at our portfolio, we do look at scenarios where rates are falling and the curve is flatter, so more of a bowl flattening scenario. So, we don't ignore that at all. We know that's a very difficult environment overall, for everyone as well as if you had a significant, quick, bare steepening of the curve. Those are the two big scenarios that we have to try to keep on top of and try to mitigate as much of that risk as we can.
So just to summarize, if I understand you guys correctly, you're fully aware that the yield curve could potentially flatten from here, but your expectations are still for higher rates and are preparing the portfolio for such. Is that a relatively fair assessment I would assume?
I think we're trying to stay fairly neutral overall in what we're doing from our rate risk perspective. But the extremes are scenarios that we're aware of and we manage that risk and we try to keep on top of that risk and mitigate it is much as possible.
Well and it's why we're diversifying our business. Okay, yes and just to summarize here, this isn't an unusual interest rate environment, of course. Everyone here has been in the business through multiple interest rates cycles for multiple decades and we understand the risks and that's why we're managing the way we're doing.
And what we're also feel like we're able, we have this flexibility now and the addition of capabilities where we'll be able to manage through whatever the scenario is with smoother earnings and more stable cash flows. And that is and that's very important and I think to question whether or not we look at potential different scenarios because of how we're set up, I think it completely misses the point.
At this time, we're showing no further questions. We will go ahead and conclude today's question-and-answer session. I would turn the conference back over to Mr. Hough for any closing remarks. Sir?
Okay. Thank you all for being on the call today. We really appreciate your interest in Hatteras and if there were any questions that went unanswered that you think of later, please feel free to give us a call and we will try to answer them the best we can. I hope you guys have a good day. Thank you.
We thank you, sir and to the rest of the Management Team also for your time today. Again, the conference call is now concluded. At this time, you meet disconnect your lines. Thank you and have a great day, everyone.
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