American Capital Mortgage Investment Corp (NASDAQ:MTGE)
Q1 2016 Earnings Conference Call
April 28, 2016 11:00 AM ET
Katie Wisecarver - Investor Relations
Gary Kain - Director, CEO, President and CIO
Aaron Pas - SVP, Non Agency Portfolio Management
Chris Kuehl - SVP, Agency Portfolio Investments
Peter Federico - SVP and Chief Risk Officer
Doug Harter - Credit Suisse
Bose George - KBW
Max Marin - Wells Fargo Securities
Trevor Cranston - JMP Securities
Good morning and welcome to the American Capital Mortgage Q1 2015 Shareholder Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Ms Katie Wisecarver, Investor Relations. Ms. Wisecarver, the floor is yours ma’am
Thank you all for joining American Capital Mortgage Investment Corp.'s first quarter 2016 earnings call. Before we begin, I would like to review the Safe Harbor statement.
This conference call and corresponding slide presentation contain statement that to the extent they are not recitations of historical fact; constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results may differ materially from those forecasts due to the impact of many factors beyond the control of MTGE.
All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in our periodic reports filed with the SEC. Copies of these reports are available on the SEC's website. We disclaim any obligation to update our forward-looking statements unless required by law.
To view a webcast of this presentation, access our website, MTGE.com, and click on the earnings presentation link in the upper right corner. An archive of this presentation will be available on our website, and a telephone recording of this call can be accessed through May 12 by dialing 877-344-7529 using the conference ID 10083759.
Participating on today's call are Gary Kain, Chief Executive Officer; Aaron Pas, Senior Vice President, Portfolio Management; Peter Federico, Senior Vice President and Chief Risk Officer; Chris Kuehl, Senior Vice President of Agency Mortgage Investments; Don Holley, Senior Vice President and Chief Accounting Officer; and Sean Reid, Senior Vice President, Corporate and Business Development.
With that, I will turn the call over to Gary Kain.
Thanks, Katie. And thanks to all of you for your interest in MTGE. The volatility we witnessed during the first quarter was pretty dramatic to say the least. By mid-February, equities were down close to 10%. Credit spreads had blown out, with investment grade and high-yield debt widening intra-quarter to levels not seen in years.
At the same time, oil prices plummeted to below $30 per barrel. However, by quarter-end, most of these markets had fully recovered. The outlier was the rates market, where treasury and swap rates dropped materially quarter- over- quarter. To this point, the tenure swap rate rallied 55 basis points and closed the quarter at 1.64%. Interestingly, this was the second lowest monthly close on the tenure swap rate, second only to July of 2012.
The moving rates would have been unusual in any quarter, but it's particularly remarkable that it occurred only a couple of months after the Fed's first tightening in almost 10 years. We attribute the move to the market's realization that the significant headwinds to global growth are unlikely to abate anytime soon, and that it will be very difficult for the US economy to be completely immune to these forces.
The FOMC took note of these issues, chose not to increase short rates in March or April and reduced their projections for rate hikes in 2016 from four down to only two. When you combine a more dovish Fed with very aggressive easing on the part of other large central banks, it is logical that interest rates across the globe are near their all-time lows. This lower-for-longer environment is supportive of our business. And as Aaron will discuss shortly, we continue to be very comfortable with the credit picture in the conforming mortgage space.
With that, I will quickly review the results for the quarter on Slide 4. MTGE reported a net loss of $0.48 per share in Q4. This result includes a $0.18 net servicing loss, which includes substantial nonrecurring transaction costs associated with our disposition of the RCS subservicing platform. This figure is consistent with what we discussed on our prior call, and we expect an additional loss of approximately $3 million to $5 million to be realized in Q2 as the final servicing transfers to Ditech occur. After Q2, we would expect our net servicing operations to be essentially breakeven by the fourth quarter of this year. This assumes no change in our MSR position.
Net spread and dollar roll income, excluding catch-up AM and our net servicing loss was $0.44 per share. The decline in our net spread income from the prior quarter was predominantly driven by the increase in our funding costs associated with the Fed's rate hike in December. While our swap portfolio is expected to mitigate the negative effects of short-term rate increases over time, timing differences between when such increases are fully reflected in our repo funding and in the received floating leg of our swap portfolio can create significant short-term noise in this relationship. Peter will discuss this timing issue in more detail in a few minutes.
In aggregate, MTGE generated an economic loss of 1.2% for the quarter, comprised of our $0.40 dividends and the $0.63 decline in our book value. The decline in our book value was largely a function of modestly wider spreads on both agency and non-agency assets.
As we indicated on our Q4 call, we felt our price-to-book ratio was unjustifiably low, and we were committed to continuing to execute sizable share repurchases. Consistent with that view, we repurchased approximately $27 million, or 4.2%, of our outstanding shares in the first quarter despite the improvement in price-to-book ratios across the space during the quarter.
Turning to Slide 6, I want to quickly review our capital allocation. The percentage of our capital allocated to agency MBS increased slightly in Q1 as a function of our decision to sell the bulk of our jumbo AAA non-agency positions. Holding these securities in lieu of agency MBS made sense against the backdrop of favorable club financing but is not compelling with wholesale funding. Correspondingly, our equity assigned to non-agency positions decreased to 45%.
With that, let me turn the call over to Aaron to discuss our non-agency investments.
Thanks, Gary. Please turn to Slide 7 for a review of our non-agency portfolio. As Gary mentioned, Q1 was one of the most volatile quarters we've seen in both the fixed-income and equity markets. While most asset classes ended slightly tighter or close to unchanged on the quarter, the speed at which markets traded off as well as recovered is a reminder of the lack of liquidity in the system and the inability and unwillingness of dealers to warehouse risk.
As an example of the spread movements, the high-yield synthetic index began the year at 471 basis points and sold off to 590 basis points, only to rally back 150 by quarter-end. Credit risk transfer spreads widened even more intra-quarter but ended roughly unchanged by quarter end. In April, spreads on CRT have continued to tighten and are currently about 70 basis points tighter then where they were on March 31. Moving to portfolio composition, the only significant change was the decrease in the aggregate non-agency portfolio size of $300 million, which was driven primarily by sales of jumbo AAA's and some higher-priced and higher-quality subprime positions.
In light of the FHSA announcement in January that eliminates our access to the FHLB financing in early 2017, jumbo AAA non-agencies are not going to make sense as a core position for us over the long term, as wholesale funding rates on these assets are not attractive. This realization, coupled with the benefits of increased liquidity of our aggregate portfolio with an eye toward facilitating future share repurchases, motivated us to swap out of most of our jumbo AAA holdings and move those positions back to agencies. Despite the volatility in Q1, we were able to pick up substantial liquidity and sell the AAA's at tighter spreads to TDA than where they were market year-end.
Lastly, the sale of our jumbo AAA's drove our lower aggregate non-agency leverage of 2 turns versus 2.3 turns at year end. With respect to fundamentals, performance has been very stable over the past few quarters, and we don't expect much to change in the near term. As we have stated before, we believe mortgage credit risk from recent origination years will be very good and that the conforming portion of the housing market will be the biggest beneficiary from expansion in household formation as well as renters looking to own.
Interestingly, the credit risk transfer sector saw its first upgrade of a below investment grade bond to investment grade this month. This drove some tightening of spreads in higher quality CRTs despite the fact that further upgrades are unlikely in the very near term. We are overweight better structured deals with higher credit enhancement levels because the payoffs for these cash flows have been relatively small. This positioning has helped the performance of the portfolio in April after the ratings upgrade.
With that, I will turn the call over to Chris to discuss the agency portfolio.
Thanks, Aaron. As Gary mentioned, the rates market rallied significantly with tenure swap rates ending the quarter within a few basis points of the lows last seen in July of 2012. Despite the extreme volatility and other risk assets during the quarter, agency MBS rents traded in a much narrower range as they continued to benefit from the relative safe haven and superior liquidity. At the bottom of slide 8, we have a time series of average daily option adjusted spreads for both 15 year 3%s and 30 year 3.5% MBS which on average were wider versus treasury and swap hedges throughout most of the first quarter.
Let's turn to Slide 9, and I will briefly review our agency investment portfolio composition. The agency portfolio increased to $3.5 billion as of March 31, given the combination of both increased agency leverage as well as a slightly higher capital allocation. Our improved outlook for agency MBS was not only a function of wider spreads. Other indicators of risk also declined as commodity in credit markets stabilized in the second half of the quarter. And messaging from Federal Reserve policymakers converged somewhat with market expectations and economic data.
And while prepayment risk is somewhat elevated, with tenure swap rates approaching levels similar to levels that were reached during the last major prepayment events of 2012, today's refi environment is relatively benign in comparison. For perspective, the most recent refi index rating of 2,067 was less than half of where the index spent the second half of 2012 and early 2013. This is primarily due to much lower mortgage crisis, given wider spreads and a flatter yield curve.
Our agency portfolio composition was largely unchanged quarter over quarter, as the combination of both season pools and prepayment protected securities positioned the portfolio to perform well in the current environment.
I will now turn the call over to Peter to discuss funding and risk management.
Thanks, Chris. I will begin with our financing summary on Slide 10. Our total on-balance-sheet funding cost at quarter end was 100 basis points, up from 88 basis points from prior quarter. This new funding level now fully reflects the Fed's December rate hike. Higher repo costs drove an increase in our overall cost of funds, which on average for the quarter totaled 139 basis points, up from 113 basis points in the fourth quarter.
As a reminder, our average cost of funds includes the cost of our repo position, our Federal Home Loan bank advances and the net costs of our settled pay fixed swap position. The increase in our average cost of funds in the first quarter was also impacted by timing differences between the rate reset on our repo positions and the rate reset on the received floating leg of our pay fixed swaps.
Given the structure of our repo funding, these positions re-priced early in the quarter at a rate that fully reflected the December rate hike. The received floating leg of our pay fixed swap position, however, reset gradually over the quarter. Thus the full benefit of the increase in three-month LIBOR on our swap position will not be fully reflected in our average cost of funds until the second quarter.
Finally, the timing of changes to our hedge portfolio and the type of hedge that we choose also impacts our cost-of-funds calculation. Forward starting swaps for example, provide a similar economic protection as currently settled pay fixed swaps, but the contribution from these hedges will not be reflected in our current earnings until these swaps become effective. Given these issues, it is sometimes more instructive to look at our quarter and cost of funds rather than the average cost of funds to get an indication of the underlying change.
On this measure, as we show in the tables in our press release, our cost of funds at the end of the first quarter was 132 basis points, lower than the quarterly average and only 9 basis points higher than the 123 basis points that we reported at year end. Looking ahead, I expect some improvement in our cost of funds in the second quarter.
Turning to Slide 11, I will briefly review our hedge portfolio. In aggregate, our hedge portfolio totaled $2.7 billion at quarter end, down from $3.2 billion the prior quarter. This smaller hedge portfolio is consistent with the shortening of the duration of our agency assets that occurred over the quarter as a function of the decline in interest rates. Given these rebalancing actions as shown on slide 12, our duration gap at the end of the quarter was 0.7 years, unchanged from the prior quarter. Although interest rates are low by historical measures, we continue to favor a positive duration gap in the current environment given our view that credit spreads will likely widen in a scenario where interest rates rally and conversely tighten in a scenario where interest rates rise.
With that, I will turn the call back over to Gary.
Thanks Peter. And at this point, we will open up the call to questions.
Thank you. The first question comes from Doug Harter of Credit Suisse. Please go ahead.
Thanks. Can you talk about your outlook for non agency investments and sort of how the equity allocation might trend over time? Kind of as jumbos are less attractive without the FHLB and kind of whether there are any other asset classes that you are looking at within that bucket.
Sure. Look, I think the reality is the agency; non-agency allocation is still likely to be capital allocation again. It's not in notional securities. We still expect to be in the neighborhood of 50-50, so to speak where it's been really over the last -- has trended in that area over the last six months to a year. What I would say is look the jumbo AAAs were sort of an agency surrogate. And to what we said on the call and to your point, jumbo AAAs over time without flub financing isn't going to make sense. Again, you pick up 50 or 60 basis points in yield and you give that up in financing, and you can't lever them anymore. You have to -- and you have bigger haircuts, so you can't lever them as much as you can agencies. So there is no rationale realistically to holding them in the long run at this point. So but that was never contemplated to be a long-term component of the non-agency or credit allocation as they were AAAs with very little credit risk.
So big picture again, we expect the capital allocation to stay in the neighborhood of 50-50 between the two. As we have announced on prior -- a couple quarters ago, we are evaluating investments in the health care sector, both skilled nursing and senior living, and that's an ongoing process. We have not made investments yet, but there is a long time line on that front. And we are very open-minded to other areas. Again, when it comes to credit risk we do prefer the conform it within the residential mortgage space. We prefer the conforming space to the jumbo space as well.
Sorry, Gary. Could you just give us an update as to -- you said you haven't made any investments in the healthcare. Is that you are still building out the team, evaluating opportunities? Is it attractive? Just give us a sense as to where we are in that process and what it might take to actually start seeing some investments there?
Sure. So no, we have a team in place as we discussed a couple quarters ago. These investments are -- take time. We are actually looking -- we are evaluating investments and have been for three months. There is a long lead time, there's due diligence; there are other factors like that. I certainly would expect us to start making investments over the next quarter or two. That's kind of the timeframe that we would expect at this point.
The next question we have comes from Bose George of KBW.
Hey, guys. Just a follow-up on the healthcare. Is that real property or bonds? Just a little more clarification on that.
Sure. No, it would be -- certainly it could be equity investments, real property. It could be debt as well. So we're looking across the gamut of those.
Okay. Great. Thanks. And then in terms of the GSE re-sharing securities, there was a transaction done by JPMorgan last month where they securitized conforming loans. Is that a structure that could create opportunities for you in the future?
This is Aaron. Yes, we think we'd participate in that transaction. We think it's likely to bring meaningful supply of credit risk to the market, and we look to participate in the future as well.
Okay. Great. And then actually just a question on just the overall structure of the company. Just based on ACAS's disclosure, you guys can internalize for I think it's a little over $50 million. Is that something that you would consider? Is it anything to help the valuation? Do you think it's feasible? Just any thoughts there.
Look, what I would say with respect to the ACAS process at this point is obviously it's ongoing and has been for a while. Our Board certainly understands all the options that are available to them, and they are actively engaged in the process. And if we have any specific update, we will obviously disclose that.
Next we have Joel Houck of Wells Fargo.
Hi, good morning. This is Max Marin for Joel. We just had one question really to the severities on slide 23. We noticed that the last two quarters -- I think your last six-month severities have been coming in a little bit higher than your base case estimates. And we weren't sure if that was related to a higher proportion of judicial state liquidations or something else. Could you give us some color on that please?
Yes, the severities on a lot of our pools -- some of these pools have -- are relatively low loan count at this point. So you might only have one or two loans liquidating in any month. So if kind of realized loss severities on a monthly basis first are lifetime or projection over the life of the pool. They're going to be a little bit choppy. And it's sometimes hard to look at specific line items like that without looking at a longer time series.
Okay, so that's just a temporary --
Yes, I think -- when we look at our actual versus expected -- so when we compare our model, projected severities on every loan that liquidates, our error tracking is within a few percent. So some of it is just the randomness of the specific loan that comes through that gets liquidated that month. But when we take into account those specific characteristics, our models project pretty well. So I think you're just seeing some choppiness in terms of the actual liquidations versus what will get liquidated on average over the life of the transaction.
And the next question we have comes from Trevor Cranston of JMP Securities.
One more question on the CRT position. On slide 21 it looks like there was a decent amount of disposition and acquisition activity within that bucket. Can you just comment on what was driving that this quarter?
Sure. Part of what you will see both when the markets are choppy but also just even over a market where we don't see spreads move around all that much is we do try to make relative value trading decisions. So while we started the quarter with roughly similar market value that we ended, we did trade that position around a good amount over the course of the quarter as we saw real bell opportunities.
Okay, got it. And with respect to MSRs, could you maybe comment on where you are seeing valuations today and, bigger picture, how you are currently thinking about potentially adding MSR's to the book as the RCS subservicing platform gets moved to Ditech?
Sure. Look, big picture right now we are not -- when it comes to the MSR portfolio, we are not actively looking at additions. We are comfortable with it relative to the size of MTG's portfolio. So we are -- adding to it at this point is not something we are looking at seriously.
Well, we have now completed the question-and-answer session. I will now like to turn the conference call back over to Mr. Gary Kain for concluding remarks. Mr. Kain?
Thank you very much for your interest in MTGE, and we look forward to talking to you again next quarter.
And we thank you, sir. And to the rest of the management team for your time also today. The conference call has now concluded. And a recap of this presentation will be available on MTGE's website. And the telephone recording of this call can be accessed through May 12 by dialing 877-344-7529 using the conference ID 10083759. Again, that telephone number is 877-344-7529, and you can use conference ID 10083759. Again, we thank you all for attending today's presentation. At this time, you may disconnect. Take care and have a great day.
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