Ben Hough - President & COO
Dean Choksi - UBS
Hatteras Financial Corp. (HTS) UBS Global Financial Services Conference Call May 9, 2012 10:00 AM ET
Dean Choksi - UBS
Good morning I am Dean Choksi, UBS' Consumer and Specialty Finance Analyst. Thanks for joining us for our next presentation. I am pleased to introduce Ben Hough President and COO of Hatteras Financial. To his right John Dalena, Chief Strategy Officer of Hatteras. Hatteras is a $3.3 billion agency-mortgage REIT with a portfolio of shorter duration hybrid ARMS. It trades at 1.06 times book with a 12.5% dividend yield and has one of the lowest expense ratios among its peers.
Thanks Dean and I appreciate and thanks to be here this week. I want to give a brief overview and discuss with you some of the details, but I want to be – want you to free to interrupt me for questions in the middle of it at any time if you have just anything you want further clarification on. Again Hatteras is an agency-only US mortgage REIT. We have a target asset class of short duration hybrid ARMS and I will give a little more detail on that in a minute on where we fit into the yield curve.
We have an experienced management team that has been together for a long time, Hatteras has been around since the fall of 2007. However we have managed almost identical strategy, agency only, ARM only mortgage REIT since 1998 and a private structure which we still own that private structure, so we are externally managed under Atlantic Capital Advisors that manage both ACM and Hatteras. So we do have an extended track record through multiple interest rate cycles and we take a long-term approach to the model and to the strategy and I will get into that here in a second but it is focused on an asset liability mix where assets and liabilities work together throughout an interest rate cycle to provide a longer-term risk-adjusted return that we feel adds value to the portfolio.
You can see the total economic return since the recession obviously it's been a pretty one-way market since 2007. But even if you go back to you know this strategy or similar strategies including our private company going back to 1998 this provides double-digit or has provided double-digit returns on average over the course of the last 12 to 13 years. So you know we take a book value focused approach. Book value represents the value of our equity, it's our assets and liabilities mark to market at any point in time.
We feel that that's you know when you're using leverage, it's one of the most important aspects of the strategy because that is what you are leveraging and it is your ability to earn. So we do take a very focused approach there. Here is a brief example of the business model, you know it's a generic example of where we might put capital to work today given I mean depending on the assets that we choose and how we choose to hedge it, but it's a generic example of what we would likely do if we were have to capital today.
Just to give you an illustration of how the model works. We have a yield basically on the investment mix that we purchase which in our case and this case might be 51 and 71 hybrid ARMS and we repo that and leverage that through the repurchase agreement market which I'll get into a little more detail in a minute, which currently we can borrow at around 35 basis points but we are going to hedge some of that -- some of that cost in order to limit our book value volatility and to lock in to some longer-term funding which in this example we use four-year slots averaged with 30-day repo and that gets to a blended cost of funds rate of 53 basis points in this example.
So we are basically managing a net interest spread, it is similar to a bank model. We are basically earning on assets and paying on liabilities and managing the risk in between those two in order to produce a net interest spread to which we can leverage to make you know a gross ROE which at 7 1/2 times leverage which is probably a reasonable number to assume for our strategy, for us today. 7 1/2 it provides us plenty of liquidity to meet daily cash needs, especially given the short duration nature of our assets and the lower volatility that, that experiences as interest rates shift that it provides us a very cushioned spot. So 7 1/2 is the right target leverage for us to use today given the current market.
So you can see with that average and then adding back the leverage of adding back the yield of our equity portion of the securities that we do not leverage. You're producing still very solid gross ROEs. Again this is similar to a bank model in a lot of aspects, but it is a much more focused disciplined strategy, it's a more cost-efficient strategy we have. You known as a REIT, we are not paying any corporate income tax we are passing it through in the form of dividend to the investors and it's an efficient use of leverage and a way to provide capital to the housing market which is obviously desperately needed and hence the opportunity today and the capital that has been raised by ourselves and the sector as a whole.
Now back to our long-term disciplined approach. Here is a table that shows sort of what we -- it's the mortgage yield curve and some of the securities -- some of the current coupon options that we would have to invest in today. We start with 51 ARMS and go all the way out to 30-year fixed and you can see the yield curve in that first column as it goes out. But you also see the duration characteristics of those securities as we have modeled here are base case duration plus what we would call your extension risk or where the duration would move to if interest rate shift at a 100 basis points and we just used a 100 here, but obviously you can use any increment higher and lower than that.
And then we add it in sort of a swap how we would hedge it an interest swap against that security and just to give an example of the net interest margin on the far right column. So the point here is, is really returns are a function of the risk you take and you know we have the option to invest anywhere on the yield curve. When we formed our company in 1998, when Hatteras came into existence in 2007, we had the option -- we still have the option of investing anywhere on the yield curve to produce returns, but again because we are, we take a long-term disciplined approach to the model we feel like the short end of the yield curve is an optimal place to be.
So while returns maybe a little tighter and net interest margin might be a little less, it's going to perform better throughout the cycle when interest rates inevitably shift whether that's tomorrow or two years from now or whenever. And that includes not just the Fed raising rates but when the yield curve shifts in anticipation of the Fed raising rates, so we want to be positioned defensively for that ultimate outcome. It's about protecting book value, it is about protecting our ability to earn, it's about having a portfolio that is flexible and can be managed as conditions change. And the shorter part of the yield curve provides more flexibility and it's really important when you're using leverage because leverage magnifies the effects of everything you're doing.
And here is an example that this kind of illustrates that point a little better and a picture. Basically this is the essence of why we are where we are on the yield curve and why we hedge it the way we do. We have two examples here of 51 ARM and 30-year fix on the same graph. It's a generic graph of current coupon. So there is a lot of different spots on this table where different securities might be. But this just illustrates the generic example. A 51 ARM has a shorter duration first of all, a duration that moves down quickly as it seasons because it is getting so much shorter everyday, because it starts, that's only a fixed period of five years and then it is going to float after that.
So it seasons quickly but it provides a stability to match our durations a little better as conditions change. Like you see the four-year swap lines up pretty well with that. A four-year swap we know what the duration of that is going to be. It is going to start at four and it is going to go to zero. We can match those cash flows with a little more efficiency and a little more certainty than if we were using 30-year fixed and trying to hedge it with say a seven-year swap which would might be something you might use for current coupon 30-year fix.
So you can see the duration range of a 30 year fix when interest rate shift and how it does not match up with the swap as conditions change and there is different ways to hedge that risk and there is different duration mixes of 30-year fixed and this doesn’t include 71 ARMS which would be in the middle there somewhere and 15-year fixed and it's all over the map here, but the main point is, is that we have a flexible portfolio that moves and we can constantly reposition. As it shortens, we can add duration. As the liability shorten with it, we can add duration on the liability side.
It puts us in a position to deal with volatility and it's a strategy that through the last interest rate cycles that we have been through has been invaluable to us in order to manage our equity which again is our ability to earn, it is what we leverage. Rising rates are the primary risk to the portfolio. They you know we manage a series of risk, but rising rates are what we are paid to manage. We have taken credit risk out of the model by investing in Fannie and Freddie only.
And what we've done as we've raised capital over the years at Hatteras and built the portfolio and positioned the portfolio on a day-to-today basis. What I'm showing here is how the assets and liabilities are going to work together. We have in the first box on the left our assets. These are all our MBS ARMs and small allocation to 15-year fixed.
And we've put them in duration bucket. So duration is the sensitivity to interest rates. It's how much these securities are going to move when interest rates shift. And we took our liability side and showed the latter, broken it down by year, zero to one year and so forth, just to show how they match up.
And what you get is an illustration of how the securities, the assets are walking down the curve, and the more sensitive the asset is to interest rate shifts, the more duration they have, the greater percentage we're hedging those securities. So we are taking interest rate risk by doing longer term swaps and get shorter term assets to it to hedge out the extension risk of these assets.
We are getting a portfolio that while only 40% of our assets are hedged, the most interest rate sensitive assets are hedged to a much greater degree. So this is a book value illustration. This is a duration illustration. This is not about hedging rising rates from an income perspective, not our borrowing cost.
But this is about hedging the volatility of the value of our securities. And as you can see that if you were to add all of this up and include our repo duration, which is our short duration liability, which is not part of this because this is not an income match, but you would see a duration gap that's very close to zero.
It's very close to zero right now which means that if rates were to shift parallel today to some degree that they would have limited impact on our book value. Now when rates shift, book value is obviously going to move because the shift is never even. But the main point is that we have a very tight gap. We're protecting book value. We're protecting our ability to earn.
Prepayment risk is another. Obviously, it's the reason we earn spread on MBS in the first place. It's the option that the borrower has to call our bonds from us. We have -- we buy current coupon, mostly lower dollar price securities. We don't want to purchase higher premium securities of a borrower that might be stuck in his mortgage that can't get out.
We'd be paying 105, 106 for that bond instead of 102.5, which is the average cost. So having a lower cost basis portfolio, we are able to absorb a higher prepayment rate than if we were to have a higher premium security. So the point is to manage -- our bonds are called at par when they're prepaid. So if we're 102.5 to par, it's much less damage than if we are 105 to par. It's half of it.
But we are going to have an organically higher prepayment rate. What we've shown here on the slide is looking back historically, just to put in perspective the rate we've had overtime. Aside from the GSA buybacks where they bought back delinquent loans in the middle of 2010, it's been a fairly steady prepayment rate for us.
So we're right in a range that we've expected. It's a very manageable range; so right where we would predict. We have updated in this slide the May prepayment number, which we got on -- we've got those numbers over the weekend. So that's a new number that we haven't put out before. And that did dip a little bit, which reflects the spike in rates in March.
It takes about 60 days for it flow through to us. So -- but with the rates coming back down since March, we would probably see that get right back up to the average, that 21 to 22 average CPR over the next couple of months. So we did get a little bit lower in May but we expect it to get right back into that range going forward. Any questions so far? Okay.
We do fund the portfolio with repo. That is there are some risks that we have to manage on that side as well. We have 29 repo counterparties, most of which we are currently -- we currently have balances with. The average haircut is about where it's been for the last year, between 4% and 5%. And the main point here is we have to maintain diversity with our counterparties.
While we are considered a credit risk to them, more so than ever they have become a credit risk to us, at least some of them. So diversity is important. But the repo market as a whole is liquid. It's healthy. As you saw in '08 when the repo market -- when everything was stressed to a large degree, the repo market was put through a serious test.
And for agency MBS, it survived. It did well. It's a part of the financial system that is crucial to the functioning of the banking system. And so, we are -- we manage it closely, but we feel like it's in good shape at the moment and we feel very comfortable with where things are. I think that we will see -- you will see more counterparties available to mortgage REITs and to us.
Going forward, I think that it's important to us to have excess capacity for the chance that anyone -- one or two counterparties may pull back at some point. Right now, we are not using the full capacity that we have available to us, and we'd like to be in that position and always want to be in that position. So we will never see us max out unless it was a stressful time in the market and we were forced to.
Here, another risk that has become a reality over the last year to two years is government policy risk. And the main points here are the government obviously has a clear intent to help those borrowers. And whether it's HARP or in some future fashion, our portfolio as a vast majority of it does not fall under the current HARP parameters or even the proposed HARP parameters.
And it's important to note that we are not -- again, we're not buying these distressed borrowers who have -- that we have to pay a higher premium for hoping that they don't prepay. We prefer to take that risk off the table because it's a risk that we can't quantify. We think it's unlikely that the government will reach these borrowers in any mass fashion.
But at the same time, it's a risk that we don't want to -- that we are not -- want to play that game. We'd rather buy the lower -- the current borrower who we understand what drives his repay behavior and something we could manage to. And most importantly, we're paying a lower premium for that securities, so the impact is less.
So again, even if every HARP loan -- even if the new proposals that came out recently were enacted, which we don't think has a lot of potential to come to fruition, but even if it did and even if every one of those loans were successful in getting through HARP, at the same time, it still represents less than 20% of our total portfolio. So even in the worst case scenario -- and we owned it at a low premium.
So even in the worst case scenario, we feel comfortable with where we're positioned for government policy. So those are the main risks that we focus on. It's kind of a summary of those risks, and feel like we're positioned well for that. Lastly, and Dave mentioned it, our cost structure is probably the most efficient in the sector. We recognize that this business is scalable.
As you add significant size or growth to this model, it does not require as much manpower to run it. And so, we did scale our fee structure so that it was aligned with the shareholders' interest. As we raise capital, our fee structure comes down. It was tiered and it started above 1%, but currently we are less than 70 basis points in total management fee because of the growth of the company. And that is significantly lower than the average in the sector.
So I think those are the main points, and we have -- we'll just open it up for questions, I guess, at this point.
Dean Choksi - UBS
Thanks Ben. We'll circulate a mike, and I'll kick it off. Can you talk about the opportunities, how you raised capital recently and kind of where that was a void?
Yeah, we did. In the end of March, we executed a secondary offering that was -- the yield curve really steepened out in March. We got the 10-year note back up pretty high. We saw assets cheapen up, better net interest margin opportunities. At the same time, there was an opportunity for us to put liabilities on the book that extended the overall profile of our swaps book out longer and at lower rates.
So in doing the equity rate, not only where we able to buy cheaper assets, we got invested pretty quickly with the proceeds. We got ahead of the move back down in rates on a lot of it, which was good for book value, and we saw some of that increase in book value in even the last week in March.
But also, we were able to put new swaps on the books that extended our locked-in funding out by another three to six months on the total book, on the total swaps book, and bring the rate down by -- I forgot -- 15 plus basis points on the average rate. So it's set up a strong liability position going forward, as well as we got the move down in rates which was we didn’t necessarily expect that, but it turned out to be a good thing as we got invested fairly early.
Dean Choksi - UBS
Would you comment on the flows of the purchases that you’re making over the last several quarters; if we would have benchmarked across the two or three most critical credit quality criteria that you think are relevant and impactful, what is the trend line in terms of that in terms of are you given the competitiveness in the market place etcetera to get incrementally more comfortable with riskier kinds of assets or are you finding that you are able to buy the same assets that you were previously maintaining the same credit and everything is fine; what’s the trend lines over the last several quarter in terms of credit?
Well, you know again we are buying Fannie and Freddie paper; we are buying ARMs only. We don’t get loan level data all the way down to get real granular on that analysis. However, given that we are dealing with a pretty steady newer production borrower, these are all pretty high credit quality that are very able to take advantage of refi opportunities as they present themselves. These are all high FICO relatively different forming.
And I think if we were to go within that universe and try to see the credit trends, I think we would have to say that they are probably improving aside from LTVs because housing depreciation has continued albeit modestly over that time period.
So I think that we have seen credit at least stay the same or maybe get slightly better. But again, it’s a small universe of borrowers that's not represented by the housing problem and the mortgage problem we have in the country today.
But just to be clear about (inaudible), but we haven't changed our investment strategy of the assets that we are investing in or 100% consistent with what we did six months ago or 12 months ago or two years ago.
Right we were still buying Fannie Freddie and newer production 51, 71 hybrid ARMs.
Definitely not; in the near term, I think there is growth in this sector has come not only from the need for capital formation into the housing market, it’s an efficient structure, it makes sense that the methods by which we have raised capital had become more efficient.
So I think that the growth is still going to be there and I think there's still going to be opportunities as far as our investment strategy, we don't see any ceiling to our growth in the near term and being able to operate the same strategy.
The ARMs market is only so big at the moment, but the ARMs market there are ways to approach the ARMs market to hopefully there will be some opportunities within the ARMs market to get paper for us, to get invested efficiently with the types of securities we want.
But as with any sector there is a ceiling and the ARMs market is smaller than the fixed market, but we are not there yet and we are a long way from it, so I don't think we see any need that that would restrict growth or compromise our asset mix.
So you talked about a prepayment risk; I mean you maybe sort of comparing contra assets to the extension risk that you see, I see that you are kind of extending out the swaps maybe as you try to manage the extension risk.
But from the perspective that given how low mortgage rates are and they probably have only one way to go, but up, so how do you manage the extension risk understanding that its 51,71 ones but if you do go to that one to longer kind of data securities?
Well, you know I would like to go to that slide again, like I said 51s, and 71s are first of all managing some of that risk for us, because they walk down the curve, they season gradually, we are hedging, the duration on these 51s, and 71s that we are buying today are in the 2.5 to 3 range, maybe a little less than three on the 71s, we are putting four year plus swaps on there. We are hedging what we think the duration would be if they shift, but we are not hedging under a percent of it.
So I think the extension risk in the securities while its there its in a band that we are willing of risks that we can manage to and we are willing to accept; the band is much tighter in the 51 as you see here. The extension risks and even in up to 200 it only goes so high.
A third year fixed or even a 15 year fixed and selling current coupon security is going to gap out even more, so that's the whole notion of flexibility in the portfolio, because as if it happens in year one, its not that wider part of event on the slide.
If it happens in year two, year three, it gets tighter and tighter. The risk is much more manageable as seasons where we will constantly be reinvesting into new ones, but we will be reinvesting in our swap positions as well and adding new swaps which will extend that up the other end.
So it moves quickly down the curve as time goes by, which puts us in a position to be able to reposition as interest rate shift. We don’t want to have blob out there that we can’t maneuver around. We are more like a, it’s just much more flexible. We are able to maneuver more quickly and be in position to change the asset or the liability side more quickly as conditions warrant as opposed to the others.
I think from an extension risk standpoint, this is exactly why we do what we do and why we do hybrid ARMs and hedge it the way we do because it’s the most flexible place to be, any shorter and it’s a little more difficult to manage through on interest rate cycle, any longer you are taking a little more interest rate risk.
Dean Choksi - UBS
Yeah the two term spreads tightened pretty considerably over the past two, three weeks? Is there a point at which it’s tight where ARM borrowers will move to longer maturities; how do you think about that?
It’s a very good question. Yes, the 10 year, two to 10 spread I think is 154 basis points this morning only 3 basis points of is lowest reached last summer. So it has flattened out significantly. That will affect ARMs production, the greater the difference between the hybrid ARM and the third year fixed spread the more hybrid ARM production we’re going to see.
So what we’ll likely see is this week, and mortgage originators around the country they will have less ARM production and more borrowers switching to fixed. As the yield curve flattens and stays there, production will be less, but there is still – we’re kind of in that [bio net] now production has dropped from 7 billion or 8 billion a month to about 4 billion to 5 billion a month as the yield curve is flattened.
So as we stay here, there is less new production available, however inevitably we’re going to get as [supplied windows] spreads will tighten and that will bring rates down a little bit and keep the yield curve a little more, so it will govern itself through supply demand of the assets on the mortgage side. But production will be less as the yield curve flattens, but there is still plenty there available for company like us to operate our strategy. Does that answer your question?
Something as the repercussions for prepayment fees; you then just begin to sell as it tightens because you scared it will spike?
No, prepayments please again, we’re going to manage it from a cost side; we’re going to accept the gradually higher prepayment rate. This is what’s been going on for the last three quarters. And you can see the repayment rate that I had on the previous slide; it’s still stayed in a relatively manageable range, a pretty tight range.
So the yield curve over the -- since you see what it moves off from the mid teens up to around 21 on the graph, but it stayed there and that’s the steps where the flat yield curve has put prepayments for us and that is very manageable number given the premium that we earn.
The only thing is we have in the past kind of prune to our portfolio, occasionally right we kind of see securities in the portfolio that we think kind of have real high prepayment risk; really outsize that we think it was going to come and in fact we will be getting part of that; occasionally we’ll prune some of that because that’s a relatively minor part.
Yes, as prepayments stay we’ve had to pay attention to some of the underlying characteristics of each pool and be careful to get out of the way of some of them. I think my time’s up.
Dean Choksi - UBS
Yeah, we’ll be available for a breakout in the Louis XVI East Room for the next half an hour or so. Thank you.
Alright, thank you all very much.