In an article published last week, I went through the case against owning agency mortgage REITs. While the focus of my discussion today is not technically an agency mortgage REIT (it's currently structured as a C-corp to capture the benefit of its deferred tax asset), the underlying business fundamentals are very similar. Nearly all the flaws that apply to agency mortgage REIT business models also apply to Arlington Investment (NYSE:AI). I would argue that owning an agency MBS with interest swaps or options, funded with repurchase obligations, will provide a return of something close to 1% in the base case (fully levered) as opposed to the double-digit "dividends," which are really capital distributions that these names pay out.
Below, I attempt to provide a specific example of the time series of returns as opposed to one particular quarter. I think you will find the trend illuminating, but also terrifying. Over the past 16 quarters, interest rates have moved up, down, and sideways. Yet the book value of Arlington persistently moves lower, calling into question the notion of core earnings.
The Melting Ice Cube
Dividend: n. a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).
While Arlington Investments currently distributes $.625 per quarter to its investors, it should not be considered a dividend. Profit is ostensibly revenue generated less costs. Arlington Investments reports a large "core" earnings figure, but has Arlington ever truly profited?
Below is a series of quarterly per-share numbers so you can review and make your own conclusions:
- Q4 2012 Book Value: $35.24 ($12.22 DTA)
- Q1 2013 Book Value: $32.78 ($9.57 DTA)
- Q2 2013 Book Value: $32.44 ($9.19 DTA)
- Q3 2013 Book Value: $31.77 ($9.07 DTA)
- Q4 2013 Book Value: $33.10 ($9.94 DTA)
- Q1 2014 Book Value: $31.50 ($8.23 DTA)
- Q2 2014 Book Value: $31.51 ($7.68 DTA)
- Q3 2014 Book Value: $30.43 ($6.43 DTA)
- Q4 2014 Book Value: $27.95 ($5.32 DTA)
- Q1 2015 Book Value: $24.83 ($4.93 DTA)
- Q2 2015 Book Value: $23.71 ($4.89 DTA)
- Q3 2015 Book Value: $20.75 ($4.48 DTA)
- Q4 2015 Book Value: $21.05 ($4.22 DTA)
- Q1 2016 Book Value: $18.86 ($4.41 DTA)
- Q2 2016 Book Value: $18.77 ($4.84 DTA)
- Q3 2016 Book Value: $18.83 ($4.20 DTA)
Q4 2012 until present seems like a sufficiently long track record to analyze this trend.
Let's sum up what's happening here:
AI paid out 87.5 cents/share quarterly from Q4 2012 through Q2 2015. AI paid out 62.5 cents/share quarterly from Q3 2015 until present. From Q4 2012 until present that amounts to $12.75 in distributions vs. a $16.41 decline in book value. The difference between $16.41 and $12.75 is $3.66. The $3.66 can be thought of as what investors lost due to fees paid to employees of the internalized manager and poor investments made.
I am certainly not a tax expert, but to further support the argument, there's actually the following excerpt from the company:
In preparing its federal income tax returns for 2014, the Company has now determined that it did not have current or accumulated earnings and profits for the year ended December 31, 2014, and therefore all of the Company's distributions to shareholders in 2014 should have been reported as returns of capital instead of qualified dividends.
To my knowledge, management has never elaborated on the above.
A group of shareholders seemed annoyed with the ongoing "policy" at Arlington and unsuccessfully attempted to replace management earlier in 2016. This is the kicker, the headlines appear as follows:
'Arlington Asset Investment Corp. Highlights Shareholder Value Creation Under Current Board of Directors' and 'Arlington Has Delivered Robust Dividends to Shareholders Over 25 Consecutive Quarters'
However, when you search for the phrase "Value Creation" in the document, nothing appears. I suppose they couldn't substantiate this claim. The same occurs when I search for the word "dividends." I would argue that Arlington has never added value and the distributions paid should be thought of a return of capital as opposed to a dividend. The future path of these distributions is highly uncertain and likely to move lower over time.
Spreads on agency MBS are too tight to achieve a going forward economic return much beyond 1%. To review the simple math, if AI hedges the duration fully and realized vol comes in on top of implied vol, investors will earn something close to 10 times the LOAS of their portfolio minus fees. If LOAS are 30bp unlevered, then investors are looking at a 300bp - fees return. Fees are easily 3% on this C-corp, putting the expected return close to zero.
I believe this management team is far worse than many of its peers in the mortgage REIT universe, yet they are being rewarded with one of the highest price-to-tangible-book ratios. If you don't believe income stocks can behave violently when circumstances change, then I encourage you to look at what happened to RSO on Nov. 14 when they cut their dividend.
I believe the "dividend yield," which is at the very high end of the group, has caused retail investors to flock to the name. But as discussed, it's much more a capital distribution than a representation of earnings power. AI's management team is quick to point out that investors are currently receiving a qualified dividend. They attempt to equate these qualified dividends to the ordinary income dividends paid on mortgage REITs. However, the tax rate they use to make this comparison is arguably far from conservative. Many investors are not in the top tax bracket and/or own REITs in tax-deferred structures. Nonetheless, if our new administration lowers ordinary income tax rates, mortgage REITs will benefit relative to this C-corp.
I am short this name. Shorting is risky, but I would expect price to tangible book on this name to drift lower to match the median of the group. This would allow for over an 20% repricing on this metric alone. However, there is also potential for MBS spreads to widen from extremely tight levels, which would cause a deterioration in tangible book value as well as price to tangible book. With every 15bp wider MBS spread, AI is likely to lose 10% of its tangible book value.
MBS spreads are two standard deviations rich relative to their 20-year history. The multiplier effect of a price-to-book re-rating on top of a spread widening can be very powerful. Also, while one waits for the repricing to occur, the carry on MBS minus fees and expenses is close to zero. Finally, the total slam dunk for the short thesis would be a tax rate change from the new administration that would diminish the advantage of owning a C-corp with a qualified dividend, vs. a mortgage REIT with an ordinary income dividend.
Disclosure: I am/we are short AI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.