Hatteras Financial Corp Management Discusses Q2 2012 Results - Earnings Call Transcript

| About: Hatteras Financial (HTS)

Hatteras Financial Corp (NYSE:HTS)

Q2 2012 Earnings Call

July 25, 2012 10:00 am ET

Executives

Mark S. Collinson - Partner

Michael R. Hough - Chairman and Chief Executive Officer

Kenneth A. Steele - Chief Financial Officer, Principal Accounting Officer, Secretary and Treasurer

Benjamin M. Hough - President, Chief Operating Officer and Director

Frederick J. Boos - Co-Chief Investment Officer and Executive Vice President

Analysts

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

Jason Weaver - Sterne Agee & Leach Inc., Research Division

Arren Cyganovich - Evercore Partners Inc., Research Division

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Stephen Laws - Deutsche Bank AG, Research Division

Boris E. Pialloux - National Securities Corporation, Research Division

Douglas Harter - Crédit Suisse AG, Research Division

Kenneth Bruce - BofA Merrill Lynch, Research Division

Steven C. Delaney - JMP Securities LLC, Research Division

Richard A. Eckert - B. Riley & Co., LLC, Research Division

Operator

Good morning, and welcome to the Hatteras Financial Second Quarter Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mark Collinson, CCG. Please go ahead, sir.

Mark S. Collinson

Thanks, Laura. Good evening, everyone, and welcome to the Hatteras Second Quarter Earnings Conference Call. With me today, as usual, are the company's Chairman and Chief Executive Officer, Michael Hough; the company's President and Chief Operating Officer, Ben Hough; and the company's Chief Financial Officer, Kenneth Steele. Also available to answer your questions are the company's co-chief investment officers, Bill Gibbs and Fred Boos.

Before I hand the call over to them, I need to remind you that any forward-looking statements made during today's call are subject to risks and uncertainties we've discussed at length in our annual and quarterly SEC filings. Actual events and results can differ materially from those forward-looking statements. The content of this conference call also contains time-sensitive information that is accurate only as of today, July 25, 2012, and the company undertakes no obligations to make any revisions to these statements or to update these statements to reflect events or circumstances occurring after this conference call. That's it for me. It's Michael Hough.

Michael R. Hough

Good morning. Thanks, everyone, for joining our call today and for your interest in Hatteras. As we typically do, after the prepared remarks, we'll open for Q&A with our entire management team.

I just want to make a couple of quick points here before we get into the nuts and bolts. We generated a solid return for shareholders in the second quarter, with dividends and book value change adding to a total return of about 15% annualized for the quarter. There was some noise around leverage mainly from the capital rates at the end of the first quarter and some isolated bond sales. We'll give more detail on that in a minute.

Now before I turn it over to Ben and Ken for that detail, just a little color on the market environment that we're in today. Since March, there's been a straight line drop in rates to once again, all-time lows across the curve, which does make the earnings environment certainly more challenging. The 10-year has dropped almost 100 basis points from the highs in March and the entire curve has adjusted to reflect the current economic and global realities.

However, the earnings opportunities remain robust, especially considering the almost 0 rate world ramp. The mortgage yield curve is still positive and ARMs remain a very attractive security to leverage and effectively hedge.

As it's been for a while, the rates markets have been one directional. The funding call slow and asset values appreciating. It's a great environment for this business model, but as would be expected yields on MBS eventually adjust to the current, which we usually equate to some earnings margin compression in a low-rate situation.

As you see, R&M was 149 basis points last quarter, down from 158 in the first quarter, which kind of reflects what the market has to give us nowadays, meaning we're close to current. Similar spread to where capital can be put to work today.

Also I just want to reiterate that we're not interested in taking on more duration or leveraged risk at this point and we'll not change the way we do things. It's the right strategy for this time and we're happy to be in position to provide investors attractive risk adjusted returns. And with that, I'll pass this call over to Ken to go over the details of the quarter.

Kenneth A. Steele

Thanks, Michael. Good morning, everyone. Our performance for this quarter was primarily driven by 2 things. First, we were investing the proceeds of our late March offering. The timing of settlements on MBS after an offering will generally mean that the quarter following will not necessarily be representative of a regular run rate. Second, the move lower in rates may continue to spread compression, as well as influenced our decision to take some risk off the table. Our net income for the first quarter of 2012 -- excuse me, for the second quarter of 2012 was $89.1 million or $0.91 per weighted average share as compared to $69.3 million or $0.89 per weighted average share for the first quarter of the year.

Although our income was up significantly, our weighted average shares outstanding also grew significantly due to the March offering. Our net interest income was $83 million in the second quarter of 2012 as compared to $72 million in the previous quarter, reflecting a higher earning assets as invested following the offering.

Our average MBS for the quarter was $21.1 billion, up from $17.3 billion in the previous quarter, ending the quarter at $22.4 billion. We also sold approximately $1.4 billion of securities during the quarter for gain of $12.2 million.

The result of these moves was an average leverage of the quarter of 7.1%, which is less than last quarter's 7.6% and our started -- stated rate -- target rate of 7.5% to 8%.

At June 30, 2012, our portfolio consisted of 93% ARMs and 7% 15 rate -- 15-year fixed-rate securities. ARMs had an estimated weighted average coupon of 3.19% and an 18 basis points coupon decrease from March 31, 2012. At June 30, we had $1.6 billion of 15-year fixed-rate securities, with a weighted average coupon of 3%.

Average coupon on our portfolio [Audio Gap] reflecting the current rate environment on our purchases. Amortization expense rose for the first quarter of 2012 going from $29.5 million to $35.9 million in the second quarter of the year. This was also generally a reflection of our larger portfolio along with a slightly higher cost basis.

As our CPR was almost unchanged at an annualized rate of 19.7% as compared to 19.6% in the first quarter. The yield on our portfolio for the second quarter of 2012 was 2.43%, mimicking the 18 basis point drop in our coupon from the first quarter.

Our cost of funds dropped 9 basis points and was .94% for the quarter, while repo rates moved up around 6 basis points throughout the quarter. This is more than offset by adding less expensive hedges as the result of the March race. This led to an interest rate spread of 149 basis for the quarter down 9 basis points from the previous quarter. Operating expenses were $6.1 million, which is an annualized rate of 88 basis points on average equity. The book value at June 30 was $27.45 per share, up $0.15 from March 31.

Despite the various market pressures, our performance on a financial basis was still strong as we generated an annualized return on average equity of 12.9% and paid a $0.90 dividend.

With that, I will now turn the call over to Ben for details regarding the portfolio and our investment.

Benjamin M. Hough

Thanks, Ken. I'd like to give a snapshot on the agency ARMs market in general and then some details on the portfolio. Obviously, yield curve flattened, and this was the major thing during the quarter for all agency MBS and ARMs were not immune.

However, being on the shorter end of the duration curve, ARM rates and prices have moved less than those of fixed, not only due to the lower duration but also in absolute terms. Furthermore, quarter-over-quarter, wider Z spreads on ARMs offset much of the decline in treasury rates with lower coupons appreciating more than higher coupons. So even with all that volatility in the quarter, prices on hybrid ARMs, depending on the coupon, ended up only about 1/4 to 3/8 of a point higher than at March 30.

All in, Hatteras book value was up modestly as our newer current coupon assets, especially those purchased from our capital raise in March appreciated the most. The tight duration match we've been running recently translated to only a modest change in book value. Since quarter end, agency ARMs have tightened somewhat more on top of even lower treasury rates, so book value is probably up since June 30.

We've note that are in our earnings release, we've adjusted the ARMs table with new reset buckets to clarify the mix of vintages and coupons we own since ARMs pricing does vary with duration.

As we mentioned on our last call, on a trade date basis, we were for the most part promptly invested after our late -- our deal in late March mostly in new production 5 1 and 7 1 ARMs and an allocation to 15-year fixed. Much of the paper was purchased forward into April May and June and interest income didn't start until settlement date. And just to clarify, since we often get asked the question, we account for the drop in forward settlement price on the balance sheet rather than the income statement just as we do all of our purchases. With forward settlements, we're exchanging the current income for a lower cost basis, and this enhances the long-term return we realized from that security. Not just in the additional yield we get with lower premium amortization, but the additional equity the balance sheet realizes when the securities settle. So it shows up both in long-term earnings power and in book value.

Addressing net interest spread. While we were looking at around 175 basis points back in March, the treasury rally and tighter MBS spreads have brought it down closer to the 140, 150 range depending on the asset liability mix we use.

On prepayments, as a whole, they stayed in our expected range throughout the quarter at 19.7 average CPR and increased only slightly to 20.3 CPR in July. But again, ARM rates have not dropped as much as fix, so the incremental impact has been less. And at this point, probably most of our borrowers have refi-ed at least once during this cycle and there's definitely some burn-out. We've been talking about a range of 18 to 22 CPR over the last few quarters, and we still think we'll stay in that range but may average closer to the higher end of that range for the next few months.

As mortgage rates continue to drop, we have and will continue to call any pulls that we think will underperform and prepay faster than others. In Q2, most of the bonds we've sold were recent purchases that were on the longer end of the curve where rates have dropped more and prepayments will likely increase the most. Managing prepay risk by removing certain securities has been and will always be part of our portfolio management process, especially in a full interest rate market. Another question we get surrounds the availability of hybrid ARMs. Our short duration assets remain very attractive and in high demand in this environment and there is more than adequate supply out there to satisfy our needs. The production of hybrid ARMs has gradually dropped off a bit to an average of around 4 billion per month, down from the 6 billion to 7 billion range last fall. Based on what we're seeing from originators we deal with and talk to, ARMs are still a valid option for many borrowers given that ARMs rates are about 80 to 100 basis points lower than fixed alternatives. So while supply has dropped off a bit for now, we can still comfortably acquire assets.

On hedging. We're now better set up for a longer interest rate cycle than we were starting the year. Our March equity deal lowered the average pay fixed swap rate by about 20 basis points, extended the term by 5 months. We not only executed swaps against our new assets, but we did some longer forward starting swaps to take advantage of the flat curve and go ahead and replace some of our higher cost swaps that mature over the next 18 months or so.

A forward start on a four-year swap currently costs about an additional 3 quarters of a basis point per month forward and we like that value. So we'll get the added duration protection from them now and we're locking in a lower future cost of funds. We may continue the strategy, but we'll keep dry powder available so we can continue to push out our swaps both longer at lower rates. We continue to target 4 to 4.5 year maturities for swaps and we'd like to run a gradual ladder book. Most of our recent executions have maturities in late 2016 to mid-2017.

In the repo market, rates were elevated a little throughout the quarter adding to the yield compression. But over the last week or so, we've seen overnight rates come off a little and we expect term rates to drop a little lower soon as well. Other than that, the repo market is steady as she goes. Last comment, while we've added a small portion of 15-year fixed paper over the past year, it is not materially added duration to the portfolio given the shortening of our ARMs. The 15-year paper has actually helped us to confidently add some longer swaps into the future for the longer interest-rate cycle. So overall, our risk profile hasn't changed in any material way and we'll work hard to keep it that way.

So with that, I'll turn it back over to Michael.

Michael R. Hough

Okay. One last thing I'd like to mention. For some reason we've recently been getting more comments about our fee structure. While almost all positive, I'm not sure if folks, especially newer investors to the space, appreciate some of the rationale behind it. So to reiterate we came up with this structure when we were formed in '07 after hearing the faults of some of the leading institutional investors in our space and based on our own experience in the business since '98. The structure was designed with a few key issues in mind. One, an agency rate is a very scalable business. And two, it is critical to align the interest of investors and management. No growth for growth's sake, no economic incentives to reach for risks, and no incentive to generate higher returns today at the expense of tomorrow. We believe these are very important concepts when dealing with a business such as hours that so highly relies on risk management. At 88 basis points, we are the most efficiently run mortgage REIT, but we sacrifice nothing in doing so. Of course, while we're proud to be efficient and glad to have our interests aligned with our long-term shareholders, we hope that we're primarily known for the thoughtful and defensive way we approach the business. Thanks, for bearing with us and now we can take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question is from Mike of Stifel, Nicholas.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

I'm just wondering if you could talk a little bit more about some of the rebalancing you did and whether we expect much of that going forward. And I guess specifically as we look through your list of bonds by maturity and by coupon, you do still have some stuff in the 4% plus coupon range. I'm just wondering how you think about the CPRs on that, the relative attractiveness of that, and as you think about rebalancing, how you look across the portfolio for what looks more and less attractive.

Michael R. Hough

Sure, Mike. We take a look first of all at what we did during the quarter in terms of what we sold and what we did with it. We pretty much has -- I think Ben alluded to in his portion of the call, we sold most -- not most but a number of our longer term, longer duration assets that had some higher coupons that we believed one, had a pretty good price movement upward; and two, have a potential to pay down quickly. We moved into -- for the most part, we went down in coupon and did some 15-year fixed, primarily 2.5% and 3% coupons that we think are going to perform better in the current rate environment. And as far as the bonds are concerned, with our older vintage 4% plus coupon tight paper, we did see a reasonable pick up there as you would expect. The HARP program is working. We had fairly rapid CPRs, but reasonable CPRs for that paper. Keep in mind we're in there at very low cost basis, somewhere in the neighborhood of mid-101s up to low 102s. Even with those higher CPRs, we're still seeing attractive net interest spreads coming off of that paper, but we will continue to monitor that. If we believe that there's the potential for those speeds to pick up even further , I think you could see us call some of that paper as well.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Great. And just a question on how you guys view the sales. I mean, there's been -- or there are some differences across different management teams in the sector of how they view the gain on sales of MBS and whether they think about that as supporting dividend or not. I'm just wondering as you guys think about the dividend going forward I mean what is your view and kind of those trading games if you will as opposed to core income, and how you think about the dividend level.

Michael R. Hough

This is Michael. Obviously, we did take a few gains this quarter, and I guess, we have really our last 4 quarters. It's not part of the business. I mean, this is a long-term strategy. This isn't a short-term dividend strategy, so it's not the driver here. However, we do have to be cognizant of certain parts of the portfolio that may underperform or over perform and I think we have to -- we have to adjust accordingly so I think this quarter's a good example of the fact that we did take some dividends. We paid a 90% -- $0.90 dividend but what is the cart and what is the horse here? So we -- this quarter, we made moves that we needed to make. It's possible we could have done more and we obviously didn't have to take any. But I think it improves the overall portfolio decisions we've made historically have been for that reason. And I think it has to be an option of ours going forward, but it's not in this business model to do that to support a dividend.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Great. And then just one final, if I may. You do have -- you guys have never had, at least as far as I know, a significant portion of kind of current reset ARMs in your portfolio, but as you guys have been around for a little while now, there's more stuff that's getting closer to reset. And yes, I'm just wondering how you view the attractiveness of that, especially with where the dollar prices on that stuff are today. If you might think about, well, how those fit into the strategy and whether those might be the next bonds to kind of rotate out?

Michael R. Hough

Let me make one quick point. I mean having a laddered hybrid ARM portfolio is -- the reason we do it is so we get current reset ARMs at some point. There's the way we like to do this, we talk about it a lot when we meet with people is that we like to match the cash flows between liabilities and assets and duration shorten as they approach reset. So having those is a good thing and in an environment right now we're much heavier having a ladder and having not everything be in current reset. But as we go forward, the portfolio will mature and it will mature as our swaps portfolio matures as well.

Operator

And the next question is from Joel Houck of Wells Fargo.

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

I guess more in line with Mike's theme there. I mean, if you look at the average spread of 149 in the quarter and I jumped on late. I'm not sure what your comments were prospectively at the spread. However, you would see like the kind of the core earnings of the business is more around 7 75, perhaps $0.80 if we get maybe a backup in rates. But given the flattening in the curve overall, what's your viewpoint in terms of the operating return on equity in the business, say, over the next 12 to 18 months?

Michael R. Hough

This might not be the answer you're looking for, but our viewpoint is that we are going to operate the balance sheet in the way we feel is -- offers the best risk-adjusted return to the shareholders and then we're going to distribute to the shareholders what we earn. Looking forward, obviously, and it's happened very quickly, it's happened in 90 days. 90 days ago we saw the 10-year at 240 and a whole lot more earnings power that can happen again very quickly but for us to say to give guidance on what we see the dividend being in the future, wouldn't make sense because there's just too many variables in that.

Kenneth A. Steele

And I will say that you have to look at pretty much everyone there is compression and as someone mentioned today in previous comments, that's just part of the cycle and were getting fairly current. But as Michael said, given how volatile some things can be, it's just hard to say it's going to be here. I do think that that's just something you have to watch going forward.

Joel J. Houck - Wells Fargo Securities, LLC, Research Division

I appreciate it is difficult. There is volatility in interest rates but if we ask you the question that 'hey it looks like we're in a Japanese type of scenario here in the U.S. and the curve is going to stay relatively tight', I'm not saying you run the business differently, you are still running it to optimize returns, but at some point it would be reasonable to assume that the dividend would have to follow where those returns went. Is that not a reasonable assumption?

Michael R. Hough

Yes, in a Japanese type scenario I think spread gets priced out of all the yield curves and anyone running this type of business would experience the same thing.

Operator

And our next question is from Jason Weaver of Sterne Agee.

Jason Weaver - Sterne Agee & Leach Inc., Research Division

This is probably more to Ben, but I was hoping you might be able to give me some color on the settlement schedule for the remaining 830 million of pending, and as well as how those securities compare with the maturity and coupons versus the existing portfolio.

Michael R. Hough

Yes. When purchased securities I think they're going to be coming on the books mostly in -- weighted probably towards July rather than August. And I think that we've been focusing mostly on -- or seeing most of the value recently and 7/1s and some of the, like Bill mentioned, some of the newer 15-year fixed paper. So I think it is safe to assume that the majority of it is in July with maybe a quarter or a 1/3 of it in August for the most part. And 7/1s and 15-year fixed mix with mostly 7/1s.

Jason Weaver - Sterne Agee & Leach Inc., Research Division

And on the coupon front for those?

Michael R. Hough

On the July paper you'd be pretty much looking on the 15 years more heavily weighted in 2.5. And for the ARM product, it'd be more in the neighborhood of -- weighted towards 7 1. So I think you're probably looking for 235 to 240 coupon.

Jason Weaver - Sterne Agee & Leach Inc., Research Division

Got, you. And second, one of the more conceptual things, you mentioned that hybrid production remains pretty low in overall proportion to originations. Could you venture a guess to what sort of structural changes to the market for either shift in the rate environment would allow an increase in production among that space?

Michael R. Hough

Steeper curve. If we got a steeper curve you'd see a little bit more hybrid production. There is a couple of factors in addition to the flattening curve that have gone into play and lowering the hybrid production, we think. One, I think that 1 or 2 large originators have had some internal issues in terms of reporting to the GSE that's being worked out. And secondly, if you take a look at the biggest originators, they're moving away from brokered loans and you're seeing the paper that's coming out now more recently, it's almost 100% or close to it retail, which has pushed down the production, but it's made the product that we're getting now even better. So it's definitely moved away from the third-party originations and more towards a retail base, which we think is going to give us better paper.

Jason Weaver - Sterne Agee & Leach Inc., Research Division

Okay. And just finally, really quick. Can you talk about the current quarter's prepayment metrics?

Kenneth A. Steele

Current and the third quarter?

Jason Weaver - Sterne Agee & Leach Inc., Research Division

Yes.

Kenneth A. Steele

Yes. Well, in July we saw a little uptick and I think it was 20.3% in July and it was then real similar and steady than what we've seen in the last few quarters. So it was well within our range and right smack in the middle of our range pretty much. So other than that, I mean, like I said, we could see the pickup closer to 21, 22 depending on burnout and what affect that's having. But not -- I hope you don't expect a whole lot different this quarter.

Michael R. Hough

Very steady today, year-to-date, as Ben mentioned the high teens. The mitigants to prepays are still out there. Ben mentioned burnout, but again, the banking -- the lending environment is still strict, documentation, pipeline, all those weigh still heavily on prepayments being as expected in the high teens, low 20s. So we don't expect a big change in that.

Jason Weaver - Sterne Agee & Leach Inc., Research Division

And the next question is from Arren Cyganovich of Evercore.

Arren Cyganovich - Evercore Partners Inc., Research Division

On your liability side, you have about 800 million of swaps maturing over the next 6 months or so. Can you talk about if any of that's going to be in the third quarter if that'll be all the of fourth quarter and your thoughts about either I guess replacing that are just letting it roll off.

Michael R. Hough

Well like I mentioned, we're been forward starting some of these swaps. There's a lot of value in the flat yield curve and go ahead and do some replacement on those swaps now. So like I said, we've been pre-executing some of those this quarter. Start dates are spread out later this year, all the way through next year as they come due pretty much. So as far as when the settlements occur, it is basically when the maturity happens on the legacy swap.

Kenneth A. Steele

We've got 100 million in August, 100 million in September this quarter.

Arren Cyganovich - Evercore Partners Inc., Research Division

Great. And would that already be reflected in the 154 swap cost to having the forward settling? Or should you have some continued benefit because I think they're 190 basis points on the settling swaps?

Michael R. Hough

It will have a little bit of improvement, if not figured in that 154.

Arren Cyganovich - Evercore Partners Inc., Research Division

Great. And then I'm sorry if you mentioned this before, but the HARP loans that you have still in the portfolio, I think you said before there were less than 10% maybe last quarter. Have they shrunk in size?

Michael R. Hough

Yes. They are down to probably closer to 9% right now, and that's through the little higher prepays than what we're seeing on some other parts of the portfolio.

Arren Cyganovich - Evercore Partners Inc., Research Division

But you said those were only like 101, 102-type of cost on this.

Michael R. Hough

Yes, we have very low-cost basis on those and somewhere in the neighborhood of 1 and 1.5 and to 1.2.

Operator

And the next question comes from Bose George from KBW.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

I wanted to first just go back to the question about leverage. When we think about leverage going forward, should we assume it's pretty close to sort of the normalized 8x again?

Kenneth A. Steele

I think, we have tried to be clear that we like to keep it in this environment with the assets that we have and the liquidity we have somewhere between 7.5 and 8. So I think that's what our target is. I'm not saying that is where we are going to absolutely be. We've been lower than that last quarter and for any -- if possible there is reasons that we would edge higher than 8 and possibly reasons of lower than 7.5, so but that's our stated target range.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. Great and then actually, I wanted to also go back to the question about asset prices. You mentioned they're up this quarter, just wanted to get a little color on how much the movement has been.

Kenneth A. Steele

Since we have the quarter Bose?.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Yes since the end of the quarter, yes.

Michael R. Hough

Depending on which securities you are looking at, I think you could look at 7/1 hybrid ARMs and probably up around 1/2 a point to 5/8 of a point and any 15-year fixed is probably up closer to 3/4 to a point.

Bose George - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. And then just lastly, the securities you're buying, the securities I'm just curious what kind of prepayments are you assuming for those?

Michael R. Hough

Because of the absolute low levels of where these interest rates are going on, we're using -- depending on whether it's 15-year versus ARM, ARMs we're using probably low-single -- mid-single digits to 8 CPRs. And on the 15-year, at least for the first 6 months to a year, we're using around 5 CPRs.

Operator

And our next question is from Stephen Laws of DB.

Stephen Laws - Deutsche Bank AG, Research Division

Appreciate the color earlier on kind of the near-term and maturity swap. Can you give us any additional color on I think it's the 1.2 billion that matures as an average maturity of 19 months, time matures within between 12 and 24, and then also maybe touch on what you're seeing with repo rates right now. You mentioned that the spike sequentially were 41 basis points. You maybe talking a little bit about on what you guys see in the repo markets right now?

Michael R. Hough

First on the swaps, we have what's coming due over the next 18 months or so as you know, in 2012 over the third and fourth quarter here, that's probably 400 million and it's going to be in that 1 3/4 quarters average rate range. Next year, they are laddered pretty steady throughout the whole year and those are even higher cost. We're probably talking closer to 2% average on that group, and that's about 800 million next year.

Stephen Laws - Deutsche Bank AG, Research Division

Great. And then with the repo markets today, where you seeing those rates kind grew in the third quarter heading August?

Kenneth A. Steele

Sure. Spread, we're looking at 30-day repo in the high 30s, low 40s still, maybe dropping down a couple of the bps of rate. The drivers of repo rates basically as we know the supply of cash and the money market fund arena, the cash demand for collateral, your balance sheets play an integral role, as we know and its termination of the overnight rate, amount of collateral in the system demand for it. So our view is it may come down a couple of bps but nothing dramatic. LIBOR seems to be very stable of late, one month LIBOR maybe inching down just a hair of late. So our view is we're going to go probably a couple of bps lower into the third quarter, and then of course, we have year-end pressures, well we have third quarter pressures and then we have year-end pressures. So we don't expect dramatic decline in the repo rates given all of the -- given that scenario.

Operator

And next we have a question from Boris Pialloux of National Securities.

Boris E. Pialloux - National Securities Corporation, Research Division

It's mostly like a more general question about the market and the hybrid market. What will be your view if the Fed starts QE3 and is quoting out like the 30-year fixed rate. Would that have an impact in terms of demand for hybrid securities?

Frederick J. Boos

It's Fred. QE3 would be designed in our view, likely for the Fed to purchase outright 30-year 3s, 3 1/2s, in that sector. The impact on hybrid ARMs -- the hybrid sector would be minimal. It's already been discounted, we think. In the market place, the Fed focus as I said it is on the 30-year current ARMs rates and origination rates remain very low historically low, the yield curve still has a nice slope to it, the mortgage yield curve. We might see some migration to fixed-rate refis, but ARMs speeds, as we discussed earlier, we think remain very consistent, very predictable. So the impact perhaps on our portfolio is we feel is modest. The profile is current coupon ARMs and low coupon 15-year paper. The positives to Hatteras are that the curve, the flattening of the swap curve would offer extension opportunities to Hatteras. The MBS portfolio should remain well bid, probably higher valuations as a consequence of the Fed doing QE3. And we don't feel this is largely impactful to our ARMs portfolio in any meaningful way.

Boris E. Pialloux - National Securities Corporation, Research Division

So directly it would be positive for Hatteras for with lower cost of swaps and probably high valuation means higher book value. Am I correct?

Frederick J. Boos

I think that is a reasonable assumption.

Operator

The next question is from Douglas Harter of Credit Suisse.

Douglas Harter - Crédit Suisse AG, Research Division

My questions have been asked and answered.

Operator

Next, then we have Kenneth Bruce of Bank of America Merrill Lynch.

Kenneth Bruce - BofA Merrill Lynch, Research Division

First, thank you for your comments and disclosure and candor. The message is not always as we would like it but that's the reality of the situation. I have really 3 questions. First, you had suggested in a couple of your remarks that just based on where the yield curve is, you're going to look to take out the duration that your liabilities. Will that be an explicit strategy to try to project earnings at some point with the expectation for rates to rise or how are you thinking about that.

Michael R. Hough

Well, I think we're thinking with one, that we are at a trough in rates, potentially, I know we said that before, but we've been doing this a long time and we feel like we need the discipline to be more defensive as we get this trough in rates. And we're doing that through increased term and notional on the swaps book. But also, when we come down to this point and rates durations especially for new production, we're going to be longer than I think most of the market anticipate if rates do go up and we are being defensive against that possibility. So yes, we are I mean it's incredibly cheap to hedge today. I mean an example of 3-year swap rate is lower than the 30-day repo rate, which for the most part we're looking up longer than that. We're swapping out the duration on our portfolio that may extend out into 2016 or 2017, and that's what we're trying to accomplish right now.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Okay. And if you look across some of your peers. There's been an increasing complexity of hedge books and I think you remained relatively vanilla in your approach. Do you think that there are either benefits or costs associated with some of the more complex derivatives in terms of hedging your mortgage portfolio?

Michael R. Hough

Yes, it's always a cost to any optionality that you gain or give, and we are -- I mean, we've been sitting here telling you that we're willing to pay that cost to forward settle swaps, which is a derivative in itself. And so we have been doing slightly different than we've done in the past but we evaluative everything. We evaluate all of the potential options that we have to match the cash flows with our assets and protect us on a duration and income on the income side if interest rates change. So it is something we will always evaluate. There are other types of hedges than what we consider and we do analysis on and the work on a daily basis. So ...

Kenneth A. Steele

I think also certainly you could say now as the curve is flat and some volatility has gone out it is making some of these more attractive than maybe they have been on the past.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Okay. And then as you look at your capital structure, is there an opportunity to think about other forms of capital other than straight equity to potentially grow from here.

Michael R. Hough

Yes, it does seem like that other markets are opening up. It's something, again, that we have to consider on a regular basis to how it fits in to the existing portfolio what is the cost of that capital and does it make sense. So we always look at it. We always -- that there's no shortage of investment bankers to pitch us ideas. So we see all the opportunities and we do the analysis. If it does makes sense to us, I think we would look to take advantage of it, but we haven't to date.

Kenneth Bruce - BofA Merrill Lynch, Research Division

Okay. And maybe if I could ask a 4th question. Sorry for that. But you mentioned in your opening remarks about the fee structure. Obviously, you've got a very shareholder-friendly one versus some of the others that are out there. There's been discussions about internalization, I believe, at the management company. Could you give us your latest thoughts on that please?

Michael R. Hough

I think what -- the conclusion that we and really I think our shareholders have come is that -- we operate very much like an internal company right now and there's a very good chance that it would make less sense to internalize but there are no plans to do it anytime soon. We -- it's turned out with the growth of this company and the way we've done things could be very favorable from an expense standpoint for the shareholders. But if it makes sense, for whatever reason in the future, you know it's always on the plate, then we'll consider it. But as of right now, we really don't have plans.

Operator

And the next question is from Steve Delaney of JMP Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

My topics have been covered in terms of repo and preferred, so I'll just thank you for the detailed color on the call this morning.

Operator

[Operator Instructions] And we have a question from Richard Eckert...

Richard A. Eckert - B. Riley & Co., LLC, Research Division

Well, but I do have one last question. I'd say about a little over a year ago or so, I liquidated my holdings in Annaly entirely and that was only after having learned what the CEO was earning. And I would like to just voice my -- I'm not asking what your CEO is earning, I'm sure I can dig that up. Obviously, you're a public company, but I would hope that we don't have any plans of that kind of distortion in the future for Hatteras that we witnessed in Annaly because I think they lost a lot of investors when that information was divulged and came quite as public as it became.

Michael R. Hough

All I can say on that is that Annaly has done a wonderful job to create shareholder value since...

Richard A. Eckert - B. Riley & Co., LLC, Research Division

They have, I agree.

Michael R. Hough

In '97, and we don't really pay attention to that. We did dedicate a portion of the earnings call to explain the expenses of -- that Hatteras incurs, which I think should lead you to a relative decision on that concern.

Operator

[Operator Instructions] I'm showing no further questions. I will now turn the conference back over to Michael Hough for any closing remarks.

Michael R. Hough

No. We don't have any closing remarks. We just want to again thank everyone for their interest in Hatteras and for being on the call and we look forward to talking about a good third quarter. Thanks.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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