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Friedman, Billings, Ramsey Group, Inc. (NYSE:FBR)

Q1 2008 Earnings Call Transcript

April 24, 2008 9:00 am ET

Executives

Paul Beattie – Director of IR

Eric Billings – Chairman and CEO

Rock Tonkel – President and COO

Kurt Harrington – EVP and CFO

Analysts

Frank Dunau [ph]

Bernard Rajmovic [ph]

Greg Hillman [ph]

Operator

Good morning. My name is Rebecca and I will be your operator today. At this time, I would like to welcome everyone to the FBR Group first quarter 2008 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator instructions) Mr. Beattie, you may begin your conference.

Paul Beattie

Thank you. Good morning. This is Paul Beattie, Director of Investor Relations of Friedman, Billings, Ramsey Group. Before we begin this morning's call, I would like to remind everyone that statements concerning future performance, developments, events, market forecasts, revenues, expenses, earnings, run rates, and any other guidance on present or future periods constitute forward-looking statements.

These forward-looking statements are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These factors include but are not limited to the effect of demand for public offerings; activity in the secondary securities markets; interest rates; our cost of borrowing; interest spreads; mortgage prepayment fees; mortgage delinquencies and defaults; the risks associated with merchant banking investments; the realization of gains and losses on principal investments; available technologies; competition for business and personnel; and general economic, political and market conditions.

Additional information concerning these factors that could cause results to differ materially is contained in FBR Group's annual report on Form 10-K and in quarterly reports on Form 10-Q.

I would now like to turn the call over to Eric Billings, Chairman and Chief Executive Officer of FBR Group. Also joining us this morning are FBR Group's President and Chief Operating Officer, Rock Tonkel; and Kurt Harrington, Chief Financial Officer of FBR Group.

Eric Billings

Thank you, Paul. As you have seen in the release, FBR Group earned $45.1 million or $0.30 per share in the first quarter. The largest single item was the $73 million GAAP reversal of pre-bankruptcy losses relating to the First NLC Financial Services. Also included in the results were $3.4 million of losses related primarily to pre-bankruptcy FNLC activities, $15 million of investment-related losses, including $3.6 million related to merchant banking and $10.6 million related to nonprime securities, a $4.2 million net operating loss at FBR Group for the quarter, and a $5.3 million loss representing FBR Group's proportionate share of 52% owned FBR Capital Markets first quarter loss.

As we look ahead, our operating results will be impacted by two items in particular. First, we expect that the $578 million first quarter investment in agency hybrid securities will increase net interest income by approximately $2.5 million per quarter going forward. Second, we expect additional cost reductions during the remainder of 2008 after having reduced our cash operating expenses in the first quarter by 28% from the average 2007 quarterly run rate to approximately $4 million.

As you know, FBR Capital Markets released its earnings yesterday and its results, like those of the rest of the securities industry, continue to be impacted by the adverse credit market conditions and the resulting slowdown in the capital markets. We believe, however, that with strong – that with a strong balance sheet and a history of doing well during market dislocations, FBR Capital Markets will fare well as the cycle plays itself out.

Turning now to FBR Group's balance sheet, and at the end of the first quarter, we had $240 million invested in cash and highly liquid agency securities, a $2.5 billion portfolio of mortgage-backed securities, of which $2.2 billion were agency-backed securities and $280 million were super senior AAA bonds, $1.6 billion of mortgage-backed portfolio funding in term repo financing with a blended maturity of February 2009, and margin requirements on agency securities remaining static at 5%.

As we stated in the earnings release, it is our intent as market conditions permit to continually to continue patiently deploying capital in a conservative substantially hedged strategy of investing in hybrid agency mortgage-backed securities. Here are some favorable aspects to our current situation. We have $519 million in capital, including $111 million of AOCI, which we will continue to redeploy over time. We are holding agency assets of $2.2 billion in a time of widening spreads. We have prudently limited our use of leverage to 4.8 times and we intend to continue on that course until we see more normalized markets.

In the second quarter, we will have the full end benefit of agency assets acquired in the first quarter. We continue to generate additional liquidity through principal pay downs and asset dispositions. We will redeploy those assets to agency hybrids with current spreads of approximately 250 basis points. In addition, as we redeploy capital in the current environment from the AAAs to the agency hybrids, we expect an incremental increase in return on equity of approximately 10%.

At the same time, as I noted earlier, we have made some progress in reducing our operating costs and expect to make further reductions over the year. And finally, we have approximately $600 million in total operating and capital loss carry-forwards that offer potential future economic benefit. With success in accomplishing these objectives during the second and third quarter, we would expect to continually improve operating profit in the REIT.

I will now open the call to questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Frank Dunau [ph].

Frank Dunau

The share buyback you had put in last year at December, you were going to have additional up to 100 million shares. It looks like you bought back about 20 million. Are we going to continue that program at this point? If I'm correct, is the book around $3.07, is that what we figure out now for …

Eric Billings

Yes, that would be AOIC, inclusive of AOIC, that's correct. And so, I think it is an important part of capital allocation. So, depending on the circumstance and an appropriate allowability, I guess, then this is something that we consider and we will certainly look to do if and as it is appropriate.

Frank Dunau

Thank you.

Operator

Your next question is from the line of Bernard Rajmovic [ph].

Bernard Rajmovic

Good morning. Quick question for you, just a couple of balance sheet items, what's the size of the I guess, because you had a subprime-related hit on, I guess it was $10 million I think the number you said, what is the size of that portfolio now?

Rock Tonkel

It is $16 million, Bernie, 16.

Bernard Rajmovic

16, okay. And I mean, how are you feeling about that, has that been written down, I guess now, to what you think is realizable, or is that what's the ratings distribution of that portfolio?

Rock Tonkel

We have written it down now to the point, Bernie, where there's in essence no near-term expectation of no near-term expectation of cash flows in the model. So, we have taken that in a near-term cash flow of the risk for several years and in essence the benefit will be step downs in the structure and cash received from the step downs. And then, as the bonds prepay repay and pay down the bonds the liability structure then you get that cash back in later years.

Bernard Rajmovic

Okay. So, you don't have to base it's not based off something like ABX index or something like that?

Rock Tonkel

No. It's based off, if these are Level 3 assets, they are based on cash flow models and as I've said, we've basically eliminated cash flow assumptions for the near-term.

Bernard Rajmovic

Okay, and the merchant portfolio, how big is that? I guess because it is throwing off losses every quarter now, so I was trying to get a sense for what is going on there.

Rock Tonkel

Merchant portfolio is about $45 million and we are liquidating positions. As we have said we would do, we are liquidating positions as we are eligible to do that. And I would say the write-downs that you've seen are this quarter were primarily structured finance. They are due to the pressure in the structured finance industry; they are private securities. They are not eligible to sale yet at this point, but as we continue to have the opportunity to sell those down when we achieve liquidity and then we will, and we will redeploy those that capital whatever we receive from those dispositions, we will redeploy to the agency strategy.

Bernard Rajmovic

Okay, and the two if I understood what you said correctly, the 280 and super senior.

Rock Tonkel

And Bernie, just to be clear at this stage on a mark-to-market basis, we are flat to that value, of that 331 valuation.

Bernard Rajmovic

Okay, all right, got it. Okay. Because I remember you had a subprime portion of that merchant portfolio. It sounds like that's all gone and (inaudible).

Rock Tonkel

No, that's all gone. There's insurance component of this portfolio, there are general industry companies that are just shy of $10 million, there's structured finance some remaining structured finance investments that are $10 million, $12 million, and there are some commercial real estate investments in there that are probably in the range of $15 million, $16 million, $17 million. It totals $44 million and they are liquidating as we have the opportunity to do so. About 25% of that today is public and will those are the first assets that we have the opportunity to liquidate.

Bernard Rajmovic

Okay, and on your non-agency portfolio, which I guess is about $280 million I think is what you said, what were the AOCI hits from spread widening?

Rock Tonkel

The AOCI there, most of the AOCI is due to as you would expect marks there, those assets are marked just right around 80, which implies about $65 million of AOCI against those assets.

Bernard Rajmovic

Okay. I may have one or two others, but I'll just get back in the queue.

Eric Billings

That's fine.

Rock Tonkel

Thanks, Bernie.

Operator

(Operator instructions) The next question is from Greg Hillman [ph]. Greg, your line is open. Mr. Hillman, your line is open.

Eric Billings

Can we move to the next?

Operator

We have a follow-up question from Bernard Rajmovic.

Bernard Rajmovic

Hey guys, looks like (inaudible) from the call here. I just want to get a better understanding on the carry-forwards. What kind of valuation allowance is held against that? What sort of clearly you guys aren't earning much now, but there's an indication of a ramp at some point, but just in terms of trying to value that, I just wanted to get some sort of understanding for what you are looking at?

Kurt Harrington

Yes, Bernie, Kurt Harrington, those are at the REIT level, so there's no income tax accounting for those for income taxes at the REIT level. So, those are just the available losses that could be utilized for the future.

Rock Tonkel

There's no debt there's no valuation downside and then there's only upside.

Bernard Rajmovic

Right, okay. And then on the just from the perspective of what you are trying to do going forward, there's clearly a difference of 4.8 times leverage and what the other I guess quite a few I don't want to be facetious but it seems there's a lot of these companies turning up left and right. But you definitely have taken a different view at least in the near term and I was just sort of curious as to are you guys are you seeing kind of the dealers just pull back so much that you have got to keep yourself lower leveraged than that, is that kind of the environment we are in right now?

Rock Tonkel

No, I would say, Bernie, that as we said at the end of last quarter, we intended to begin to redeploy the excess liquidity position at that point to the agency hybrid business primarily and we intend to continue to do that. We began that during the quarter. We added $600 million of assets with spreads well above 200 basis points and we would expect to continue to do that. I think we think about leverage maybe a little bit more cautiously in this environment than we did then. I think we look at six to eight times as an appropriate level to lever the balance sheet, which would give our total capital position, bring as to something like a $4 billion balance sheet sort of at the midpoint of that, which would suggest there is something on the order of $1.5 billion of incremental asset that you could add and still sort of be in the mid-range of that six to eight leverage ratio.

And obviously, the benefit of that here is that at $1.5 billion or thereabouts, you add about $35 million in net interest income to the earnings of the company. And that's the course that we are seeking to pursue and we are on that. We are in sort of at the beginning of that ramping stage and we feel like in this environment six to eight is certainly prudent leverage. And margin requirements being what they are sort of static at 5%, we've seen no pullback as it relates to the counterparties on the agency side. And so, we feel like we have the opportunity in front of us and we are moving in that direction. We are doing so very thoughtfully and carefully in this market environment.

Eric Billings

Bernie, just a quick comment, if you think if you look at our balance between the merchant tax receivable and the AAA assets, which over time we are liquefying and turning into cash and redeploying into the hybrid market, that total is about $200 million of capital that over time we will be redeploying. And then again, adding to the hybrid portfolio and again using a spread of north of 200 basis points, that will lead to significant increased profitability at a quarter-to-quarter basis.

As we accomplish that now, that will be bumpy and it's not, we can't be clear precisely clear how that will occur, but in any case certainly over the ensuing quarters, we fully expect that that will continue to occur. And that is our objective in addition to, as Rock said, continuing to systematically build the portfolio to our desired objective at six to eight times. So, that's really what we are looking at and then again simultaneously reducing the cost structure and the totality of that will produce what we think will be very acceptable cash returns on equity. And particularly because the trust preferred capital that we have, the return on equity that we have in the company deployed, we think could be very acceptable.

Bernard Rajmovic

Right, and if I look at that when you are talking about deploying that 220, if I look at it, it was 280 at the end of the last quarter you said. It is 220 now. I guess some of that 60 is amortization and some of it is just AOCI markdowns. Am I looking at that the right way or …

Eric Billings

Yes, you are, Bernie. The two – and that's actually 279 now I think is the face on the AAA portfolio and the mark on that is roughly 220. So, you mark down by approximately just over 60 million. As these are triple super senior AAA assets, we obviously fully expect to get all of that capital back over time at the very least. And so, whether it is just pure pay-downs or the pricing of the bonds continue to move back toward par, and then we are able to sell those and redeploy that capital into the agency, in either case over time that's exactly right. That is what we will be doing and as Rock as we mentioned in the script, we earn about 9% on the AAA assets on a spread basis today. And obviously, we would expect on a redeployment into the hybrid assets in the current environment, that we would pick up above incremental 10% in equity returns as we do that assuming the environment stays reasonably consistent.

Bernard Rajmovic

And how fast will that amortize, the non-agency?

Eric Billings

Well, if it were just through amortization, about 2.5 to 3 years would be is that about right give or take, 2.5 to 3.5 years through pure pay-downs, if there were never an improvement or recovery in the pricing of these assets in the marketplace which we obviously don't expect. We do expect they'll move back sooner than that.

Bernard Rajmovic

And last question just on management incentives, I guess a couple of months back, there was just some discussion of the pay and whatnot and I know Eric has foregone a bonus for a couple of years and you got one this year but or last year. But, just going forward, how what are the incentives and what are those what metrics are those going to be based on?

Eric Billings

The current comp plan, Bernie, is going to be released in the proxy statement next month. Next week, excuse me, and it will go through those. I will tell you though it is very consistent with what it has been in the past and it is profitability-based. So, it would be a percent of profitability and so it would end up being consistent with the normal pay plans of the past.

Bernard Rajmovic

Okay, great. Thanks.

Eric Billings

Thank you.

Operator

Your next question is from Greg Hillman [ph].

Greg Hillman

Just one quick question, it shows the employee count for the FBR Group of 726 people, is that correct?

Kurt Harrington

That's consolidated. That incorporates CMC, the total personnel at Group is a dozen or less.

Greg Hillman

Okay. And then, Rock, in terms of using the tax asset, I take it can you use that to shield assets from the FBR Capital Markets income?

Rock Tonkel

No, it's not. CM is not consolidated for tax purposes.

Greg Hillman

Okay. Then how would you expect to use that tax loss at some date in the future?

Rock Tonkel

Well, there are a number of things I think we talked a little bit about on the last call. There are a number of things we could look at, but one in particular would be that given those tax benefits, earnings would be as we generate earnings, we would not be required to pay dividends on that. We would retain that, we would have the ability to retain that capital.

Eric Billings

Or we would pay that out in the form of cash dividends and those dividends would be return of capital and not taxable, which will and we will make judgments and determinations as to when we restate the dividend. But, at that time, it would be these dividends for a considerable period of time would be tax-free.

Greg Hillman

Okay. And Rock, I know you mentioned winding down the merchant portfolio earlier, but in the past, part of the strategy at the FBR Group was to like co-invest with the FBR Capital Markets in deals. And are you going to still do that?

Rock Tonkel

No. We are the business of the REIT going forward is to deploy all available liquidity to the agency business and primarily to the hybrid agency business where we believe the highest risk-adjusted spread opportunity is. So, as we receive capital from pay-downs of assets from dispositions of merchant, from cash flow on the asset base, and as Eric said, as we as the value accretes on the AAA's back toward par, we redeploy that capital. We will be redeploying all available capital that is not currently deployed to the agencies to the agencies given that risk-adjusted return pickup.

Greg Hillman

Okay. And can you just talk about the dividend policy? You just mentioned possible return of capital, but do you expect to increase either the dividend or the return on capital any time soon? And how when would you make that decision on a quarterly basis or …

Eric Billings

Greg, I think this is something that we will be talking about significantly over this quarter, and as we said in the script, we expect to return to cash operating profit in the and so in future and at that time, we will make a judgment as to whether we think it is better to retain that capital or whether we think the shareholders will be better off if we paid it in the form of dividend in allowing the stock to trade more appropriate to the value of the business, which would then create other opportunities for the company potentially. But, we will make that judgment over the next probably over the next 90 days or so.

Greg Hillman

Okay, thank you very much.

Eric Billings

Thank you, Greg.

Operator

There are no further questions at this time. Mr. Harrington, do you have any closing remarks?

Kurt Harrington

No, thank you. Thank you for your participation.

Operator

This concludes today's conference call. You may now disconnect.

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