Capstead Mortgage Corporation (NYSE:CMO)
Q1 2016 Earnings Conference Call
April 28, 2016 09:00 AM ET
Lindsey Crabbe - Manager, IR
Andy Jacobs - President and CEO
Phillip Reinsch - EVP and CFO
Robert Spears - EVP and CIO
Joel Houck - Wells Fargo
Steven DeLaney - JMP Securities
Bose George - KWB
Good morning, everyone, and welcome to the Capstead Mortgage First Quarter 2016 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. After today's presentation there will be an opportunity to ask questions. [Operator Instructions]. Please also note today's event is being recorded.
At this time, I'd like to turn the conference call over to Ms. Lindsey Crabbe, Investor Relations. Ma'am please go ahead.
Good morning. Thank you for attending Capstead's first quarter earnings conference call. The first quarter earnings release issued yesterday April 27th and is posted on our website at www.capstead.com under the Investor Relations tab. The link for this webcast is also in the IR section of our website and an archive of the webcast will be available for 60 days. A replay of this call will be available through July 28, 2016. Details for the replay are included in the yesterday's release.
With me today are Andy Jacobs, President and Chief Executive Officer; Phil Reinsch, Executive Vice President and Chief Financial Officer; and Robert Spears, Executive Vice President and Chief Investment Officer.
Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, and are based on certain assumptions and expectations of management.
For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website. The information contained in this call is current only as of the date of this call April, 28th. The company assumes no obligation to update any statements, including any forward-looking statements made during this call.
With that, I will turn the call over to Andy.
Good morning and welcome to our first quarter earnings call. And thank you for your interest in Capstead.
Regarding the market, as people know, we began a year with at 10-year treasury at 2.27% and the month of March, it was expecting up to 4.25 point increases on Fed fund rates in 2016. However, with the concerns with the global economic growth that those effectively curtail the anticipated rate increases and with these diminished economic growth prospects, the 10 year notes have moved substantially lower hitting on February 11, hitting a low of -0 on a sloping prices of 166. So that's about a 60 basis point decline since the end of the year.
The substantial decline also had its impact with coupon interest rates on 30-year low cost refis, which is below 4% during the quarter. Although mortgage prepayments on our portfolio were lower in the first quarter as we had expected due to primarily the seasonal factors. Those with mortgage coupon rate around 4% at this point. We anticipate prepayments to increase in the spring, due to refinancing activity. In addition to higher prepayment due to seasonal factors, which will increase our invested premium amortization in coming quarters.
In yesterday's statement, the federal open market committee stated that economic conditions will evolve in a manner that they believe that will not only gradual increases in the Fed fund rates, and that the Fed fund rate is likely to remain for some time below level that we're expected to prevail in the longer run.
In summary, I believe the market view, regarding the statements, as we think the market use them as diversion and as a result I think the conclusion is that the interest rates are likely to remain lower for longer as reflected by the Fed funds due to its right now and now expecting like only one more Fed fund rate increase in 2016 down from 4 beginning of the year as I said.
Regarding our operating results, first quarter net income was $27.4 million or $0.25 per common share, compared to $28.4 million, $0.26 in the previous quarter. Financing spreads were unchanged quarter-over-quarter at 90 basis points. While the investment portfolio yield increased 9 basis points during the period, 3 basis points of this was relative to the cash yield on the portfolio, which is somewhat reflective of higher rates on - higher indices on the portion of portfolio and resets during the period.
For example, the 12 months LIBOR rate increased an additional 3 basis points during the first quarter to where it's now around 1.21% that's followed an additional 33 basis point increase in the fourth quarter. So we're seeing the industry is moving higher to which our portfolio - a lot of it we said. It's a 58% of our portfolio is the current reset product and that portfolio whilst reset at least once over the next 18 months, which should result in higher portfolio yields.
The remaining 6 basis points of the year-over-year increase that we experienced in this period was the result of lower investment premium amortization as more prepayments declined 1.4 CPR to 18.23. And as we stated in the past, each four percentage points in CPR quarter-over-quarter has worked about a $1.5 million and quarterly premium amortization, but plus or minus and the 6 minus. So the decline in CPR represented the majority of the yield improvement we saw on our assets.
Borrowing rates after adjusting for hedging activities averaged 83 basis points, which was a 9 basis point increase quarter-over-quarter, which offset the yield improvements, I was just talking about. But the 9 basis points was primarily attributable to the Fed fund raise increases that we saw in the December period.
In addition, as we talked about in January, those Federal Housing Finance Agency, the regulator of the FHLB finalized rules, which preclude captive insurance like, the subsidiary that Capstead has. I was the member of the FHLB. They're real - we won't be a member after February 2017, but during the time, the regulator induced moratorium effectively prohibit that from entering into any newly branches [ph]. So, basically whatever we have that was short-time and as it’s rolling, we have to basically move it back to the regular repo system. And this contributed marginally at the higher rates on our portfolio, as we have lower cost FHLB advances report replaced with higher cost repurchase arrangements.
Overall, our borrowing cost, we feel confident, fairly comfortable with. We used short-term two-year interest rate swaps and we have longer-term maturities, which we believe with the combination of our improved or the nature of our adjustable rate portfolio, which we set higher with higher coupons in the environment, we're seeing, we think our portfolio of margins will remain fairly commending in here.
Regarding our portfolio, our book value declined 1.5% quarter-over-quarter. The unrealized gains portfolio was slightly better than it was at the end of the year. However, the improvement that we saw and the value of the portfolio was offset by unrealized debt losses on our slot book that we used for hedging purposes.
Overall, our investment portfolio, we closed the quarter at $13.8 billion as runoff, $768 million exceeded the portfolio's acquisition of $448 million. We ended the quarter at 9.14 leverage of our long-term investment capital. And as we said many times before, we’re comfortable with this level of leverage given the health and breadth of the financial market and the agency market as well, and with this adjustable rate nature of portfolio.
The duration of our investment portfolio, this is the asset. This is it on the net basis. The assets are one of the lowest in the industry, the 11.5 half months. So that the focus is really looking on behalf, after considering the borrowing, which have a duration of eight and three quarter's months. Our net duration is about 2.5 months. So, I think the key focus is on the asset side, the 11.25 [ph] is one of the lowest in the industry.
A few final remarks, people have seen a difficult quarter so far in 2016 for mortgage rates. As you recall back in January, our stock price was trading about 75% over the equipment - book value, representing what we believe to be an attractive investment opportunity.
After our announcement on January 27th, that our board has authorized to share repurchase of $100 million of common stock. Our common stock price has moved higher and now [ph] rates about 87% of book value of our current value.
And as such with the improvement we’ve seen in the stock price, we haven't had any share repurchases to-date. And, kind of towards that I want to remind investors, we're internally managed, so we're not conflicted with the amount of capital outstanding with some of our sterling advice peers are proceed to be.
Now additional, management hold the meaningful state in the company's common stock, so as you can be cost, we're focused on what is in the best interest of all shareholders.
And so with that, I will open up the questions.
Ladies and gentlemen, at this time, we'll begin the question-and-answer session. [Operator Instructions]. And our first question today comes from Steven DeLaney from JMP Securities. Please go ahead with your question.
Thanks. Good morning, everyone. Thanks for taking the question. Robert, I noticed in the press release there, you gave your quarterly CPRs sometimes Andy will comment on monthly or the current month, would you - are you able to provide us with say, the March and April monthly CPRs?
Well, we didn't disclose that but generically ARMs, I would say we're in the first quarter and then in April and they kind of [indiscernible] up from the high teens to the low 20's and I think that's probably a pretty good estimates for the remainder of the quarter. So that's kind of if - you just look at your market in general as we saw.
Okay, that's helpful. And I think obviously we can look at things like EMBS and get sort of the generic for like fab1, LIBOR, ARMs and we do see -
And obviously it's a little different and we have the season post to reset portion and those be generically haven't really picked up that much, they are still kind of in the mid-teens and then you have longer reset paper that's in the low to mid-20's generically write-down.
Yeah. I wanted to ask about the resets. I mean it's kind of a unique paradox, it's unique the Capstead I think maybe a little bit and worth. But this post-reset coupon rollup, I mean and on the surface that obviously feels like a good thing, right? And I guess the challenges I see there, I have one specific question if you can just kind of help me with some math.
So, I'm thinking about let's say you are showing a fully index WAC of about 262, 16 basis points higher than the current net WAC. Now, if we just looked at the loans index to one month LIBOR, right? So we are looking at say 120-125 on LIBOR. I think your average margin is as far as the EMBS coupon is something in the neighborhood of 170 is that kind of been why.
Yeah, the one year LIBOR and you are exactly right. So let's say one year LIBOR is at 120 and the margin is at 170, so that gets you to 290 plus servicing and so I think what you're adding is what are the gross mortgage rates and the borrower going to be - probably going to be somewhere in the 3 and 3.8 is highest 3.5 area. And so -
I had circled 345, so boom I think I was reading your mind on that one. So the challenge in I mean I looked it well this morning. They are quoting a new fab1 at 3 and 8 and a new 7, 1 and 3 and 3, 8s. So I mean I guess a couple things, what - I'd like your words not mine. So I guess what keeps the guy with you as his reset is pushing up equal to or even slightly above where he can put a new ARM assume forget the 30 year transfer just the guy who wants to go ARM to ARM.
Well, a lot of it has to do with, first of all, I think if you roll in closing cost and everything else, if you look at - I would say a no cost that there is such a product 5 1 now would be closer to 3 and 3.8 to 3.5, a 30 year.
4%. So yes, from a pure math standpoint he may have some incentive. But some of these loans are so seasoned and they have small loan balances. Some are still predator some degree from an LTV standpoint. And you just a get a burnout faster on a lot of these post-reset. One of these guys that have been in ARM products someone for as long as 15 years and so it's just becomes a burnout issue more than anything. One thing and this become a kind of a hot button in the post-reset world are items that are coming out of their item period. Now that's a different animal [ph], because -
That's a 10 year IO, right? So if these were '06, '07 -
Yes, the other [indiscernible] in your IO and now he is at 3 and 3A, and he switches to a fully amortizing loan for 20 years, he may be more prone to refinance into a fixed rate mortgage. But the same term or something like that, so those loans are definitely prepaying faster and because of that they are trading at a discount and so the IO portion of the post-reset market had seen some spikes and speeds. You are not really seeing that in the non-IO portion of the post-reset market.
Yeah, make sense. All-in0all it sounds like while it's a complex issue. It sounds like the rollup is providing a net benefit as opposed to a drag in terms of looking the impact.
Yeah. I think people have been in the last couple of trends have been pleasantly surprise at the post-reset market, I think there were some prepaid fears out there which cost the paper to cheapen up and they are not materializing right now.
Great. Okay, thank you. And Andy one for you just to finish up, if I could, I noticed looking back over the last six quarter and I was slightly high here in the first quarter and one of the issues was incentive comp, I was too low and that cost me a penny on my $0.27 estimate. But looking back like say, the last three quarters compared to the three quarters prior to that I guess starting with the third quarter of last year there was a pretty significant pick-up especially in short-term incentive comp. And it looks like the recent run rate has been sort of about 1.3 million short-term may be half a million long-term so 1.8 combined. I know it is a complex plan and based on relative TER et cetera but just for modeling purposes do you think that current run rate we have seen in the last two months or three months would be logical for us to use for the balance of 2016?
No, I think that if we go back into the couple of quarters last year that is probably more fair representation and you mentioned a lot of our plan is relative performance to our peer group and because of that we don’t have perfect knowledge at points in time which is why at the end of the year we were under accrued relative to where we were going to be at the end of day after everybody reported so, that is the pick-up that you saw on the first quarter. So I think you could reasonably expect I mean depending on what we are seeing in the market and relative performance for economic return on our portfolio relative to the group appears that you follow as well. I think you can look at that and probably get a fair good gauge of where that is going to be year-over-year if you look at 15 to 14 and where we are going to be in 16.
Okay, well. Thanks for the time and comments.
You’re welcome Steve.
Our next question comes from the line of Bose George from KBW. Please go ahead.
Hey, guys, good morning. Actually just a quick follow-up on the prepayments, Robert do you say that low 20 CPR from April was a good run rate for the next quarter?
Well, I just think if you look at where people are projected fixed rate prepayments for the second quarter they are looking at the April number and then may be a slight uptick but fairly flat so, I think the April print for ARMs are probably close to what they should be for the quarter.
Okay, great. Thanks. Switching to the swap so 1.1 billion that expires in April 1st are you just replacing that with two year swaps?
We are always really our swap booking we kind of look in the context duration gap and so it doesn’t matter dollar for dollar but if you know our duration gap change a little bit closer two and half months so, we have been managing to I say two months to three months’ duration gap for the last year and we will probably stick pretty close to that and add swap as we buy bonds and keep that duration gap where it is.
Okay. Make sense. And then actually just one on book value can you just talk about how assets perform since quarter end especially the shorter recent arms?
Sure, I'd say generically the core end say new as you buy ones or many down a quarter of a point or so if it sells off, they pretty much traded on spread short resets are fairly unchanged in price, there is a decent bid for short reset paper right hit a little bit in February and spreads volume now and kind of language for a while, but you've got buyers coming back into that space so I would say at quarter end it is pretty much unchanged even though rates are higher.
Okay, great. Thanks.
[Operator Instructions]. Our next question comes from the line of Joel Houck from Wells Fargo. Please go ahead with your question.
Good morning, guys and thanks for having the call. So one of the emerging things I guess in the macro sense and we are hearing on these calls this notion that the Fed is going to be lower for longer, in light of that have you had internal discussions or more longer range thoughts about hedge ratios, it seems like what's happening in the space is companies you guys are no different, companies are thinking about hedging their book relative to historical models and that includes classic tightening cycles.
And so what seems to be happening is you get this kind of traditional hedge ratio, which leads to kind of more slippage in book value quarter-over-quarter, because the Fed never - you know, we continue to see the yield curve kind of compressed and short rates never move up, as much as, the forward curve indicate.
So I'm just kind of curious as to, how you guys think about and I know your asset class is very unique versus a lot of the other players, but I think it'd be helpful if you kind of talked about that and there is no change and perhaps maybe expand on that as well?
Sure. Fortunately, we’re hedged on the shorter part of the curve, so you’re not seeing the big - we don’t see a big extension in our book and we don’t have the duration mismatch problems hedging the fixed rate book we have. So having said that we really haven't been hurt from a hedging standpoint, because the rate moves has been spread lightning moves and that you really can’t hedge that. And so, we’re not seeing a big gap between our hedge performances on a rate basis versus what our product does, it’s purely spread lightning. And so, I don’t think given the nature of our book, we’re going to change our hedging strategy at all.
Well, I think as we said a little bit earlier CE kind of targeting and has for a number of years, they're kind of the net duration down around three months or so, so it’s plus or minus a little bit from there.
Yeah. And really if you look at it, we for the most part don’t really hedge our short resets, we’re targeting our hedge as lower on what we consider long resets which are 51 and so it’s not like we are going to be over hedged at any point of time versus rate book given the floating rate nature of our portfolio.
One thing, Joel. This is Phil. One thing that does create a little volatility in our book value is our $100 million of 20-year swaps on our swapping up the variable rate period of our $100 million of unsecured borrowings, that was a dime negative to book value at this quarter, so that bounces around with the changes in rate environment, you don't get the offset, because the liabilities themselves aren't mark-to-market on the balance sheets.
Okay. And, that’s actually a very good point. On the basis risks, it’s - obviously it’s something that is very difficult to hedge, some have kind of made an attempt in terms of IO, MSRs a lot of which I guess haven’t been that successful. Your asset class given in its very short duration in nature, I would assume that that probably doesn't make a lot of sense for Capstead to look at IOs or MSRs and things like that just kind of want to confirm that, you’re thinking along those lines.
No, I mean, by default premium ARMs have substantial IO risk already built in and so, you’re kind of pressing the bet by using an IO to hedging ARMs book, I mean, we’re basically long IO, we're long floaters, premium floaters. So that really doesn’t fit within the structure of our book like Mike said, within fixed rate [indiscernible] book.
Okay. And then just finally, did it annually had a risk merger was fairly significant in terms of size and really kind of first larger deal we’ve seen in this space. Can you make some comments about overall consolidation and how you view Capstead in kind of if we see a consolidation way of buyer or seller and given kind of specialty that the kind of what seems now like a permanent discounted book for all the players? And then other flipside to that is what is the - you talked about no stock buybacks, stocks rallying from 75% to 87% of book, how you think about shareholder value in grey zone or you're below book, but maybe it's not as attractive to buy back stock, because of the friction cost.
Well I'll start with your latter question first, relative to the buyback, as I made the point that we're internally managed, we're not - don't receive the management fee based on capital under management or anything. So we're looking at this from - we're going to do the right thing for shareholders in our interest to do that.
The key - I think the key here is that as where we saw the stock price earlier this year we saw it was an attractive investment from that standpoint. The other side of that is what's what are the assets that Robert it has opportunities to buy and with the volatility you had seen kind of in the middle of the quarter due to the opportunity to spread widening and such it became more attractive to be buying bonds especially when your stock price has moved up substantially.
So it's always the balance between those that you're trying to get correct and there was a good opportunity to pick up bonds to some extent later in the quarter. So that's the way we think of that. We're always looking. If we were to move back obviously towards that $0.75 on the $1 type range, which I'm not anticipating moving to any kind of soon, I think it's much more challenging give and take from where you buy bonds or you buy stock.
But now your first question, I am hesitating to say too much regarding the consolidation of the industry. I know quite a number of analysts have been talking about the consolidation and seeing this and that. I mean we Capstead, we're having been in business as long as we've had. We've heard these types of discussions a long time ago and through the year. I think it's finding mergers is kind of is, I think it's very unique situation that fit the point two different company. And it has to work for both parties and I think that's kind of what the annual pattern [ph] deal was, if it fits both of them is what we're trying to accomplish.
I think it's a bit more challenging. I don't think we won't see a wholesale of consolidation in our industry per se. I think the three of the other transactions that occurred two are more kind of affiliated in nature relative to the managers and the other one appeared to be kind of strategic which gave a company that haven't been had a public platform and opportunity to basically get a public platform. So those are kind of I think very unique. That's the [indiscernible] that's kind of, it just winds up to where it fit for both.
Yeah, okay. Well, again guys. Thanks for the time and appreciate the comments and color.
[Operator Instructions]. And ladies and gentlemen, at this time, I am showing no additional questions. I like to turn the conference go back over to management for any closing remarks.
Thanks again for joining us today. If you have further questions, please feel free to call. We look forward to speaking with you next quarter.
Ladies and gentlemen, that does conclude today's conference call. We do thank you for attending. You may now disconnect your telephone lines.
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