Arlington Asset Investment Management Discusses Q2 2012 Results - Earnings Call Transcript

Jul.31.12 | About: Arlington Asset (AI)

Arlington Asset Investment (NYSE:AI)

Q2 2012 Earnings Call

July 31, 2012 9:00 am ET

Executives

Kurt Ross Harrington - Chief Financial Officer, Chief Accounting Officer, Executive Vice President and Treasurer

Eric F. Billings - Co-Founder, Chairman, Chief Executive Officer, Chairman of FBR Capital Markets, Chairman of FBR Asset Investment Corporation and Chief Executive Officer FBR Capital Markets

J. Rock Tonkel - President, Chief Operating Officer and Director

Analysts

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

James J. Fowler - Harvest Capital Strategies LLC

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

Operator

Good morning. I'd like to welcome, everyone, to the Arlington Asset Second Quarter 2012 Earnings Call.

[Operator Instructions] I would now like to turn the conference over to Mr. Kurt Harrington. Mr. Harrington, you may begin, sir.

Kurt Ross Harrington

Thank you very much. Good morning. This is Kurt Harrington, Chief Financial Officer of Arlington Asset.

Before we begin this morning's call, I would like to remind everyone that statements concerning future performance, market conditions, risk spreads, private-label MBS trading activity, liquidity levels and credit trends, agency-backed MBS prices, cash earnings, book value, portfolio allocation, plans and steps to position the company to realize value and any other guidance on present or future periods, constitute forward-looking statements that 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, changes in interest rates, increased cost of borrowing, decreased interest spreads, changes in default rates, preservation of utilization of net operating loss and net capital loss carry-forwards, impacts of regulatory changes, including actions taken by the Securities and Exchange Commission, impacts of changes to Fannie Mae or Freddie Mac, actions taken by the U.S. Federal Reserve and the U.S. Treasury, availability of opportunities that meet or exceed our risk-adjusted return expectations; ability to effectively migrate private-label MBS into agency-backed MBS, ability to realize a higher return on capital migrated to agency MBS, ability and willingness to make future dividends, the failure of sovereign or municipal entities to meet their debt obligations or a downgrade in the credit rating of such obligations, ability to generate sufficient cash through retained earnings to satisfy capital needs, changes in and the effects on the company of mortgage prepayments fees, use of proceeds from our recently completed equity offering, ability to realize book value growth through reflation of private-label MBS, the realization of gains and losses on principal investments, the outcome of certain litigation and investigatory matters,, available technologies, competition for business and personnel, and general economic, political, regulatory and market conditions.

These and other risks are described in the company's annual report on Form 10-K for the year ended December 31, 2011 that are available from the company and from the SEC. And you should read and understand these risks when evaluating any forward-looking statement.

I would now like to turn the call over to Eric Billings for his remarks.

Eric F. Billings

Thank you, Kurt. Good morning, and welcome to the second quarter earnings call for Arlington Asset. I am Eric Billings, Chief Executive Officer of Arlington Asset and joining me on the call today are Rock Tonkel, President and Chief Operating Officer; and Brian Bowers, our Chief Investment Officer. Thank you for joining us today.

You can see from last night's press release that Arlington reported core operating earnings of $11.3 million, or $1.16 per share-diluted for the second quarter. Overall, this was a positive quarter for the company. Return on equity from core operating earnings -- operating income of 20.5% was driven by several factors. The deployment of the proceeds from our first quarter capital raise took full effect from the end of April onward and added spread income without increasing our G&A expense.

Continued low prepayment speeds in the company's agency mortgage-backed securities portfolio and high unlevered cash yields from the private-label mortgage-backed securities portfolio were an important contributor again this quarter.

Finally, the company recorded realized net cash gains from the sales of agency mortgage-backed securities during the quarter of $0.14 per share.

We are seeing very encouraging performance from both our agency and our private-label portfolios. In the agency portfolio, all of our assets were specifically selected for prepayment protection of some type. Approximately 53% of our portfolio was originated under HARP programs. And our remaining assets consist of either low-balance loans, low-FICO loans, high-LTV loans or loans with other prepayment protective features.

These loan characteristics significantly reduced the economic incentive to the borrower to refinance or constrain the borrower's ability to refinance. And because the loans underlying our agency portfolio on average were originated in the last 12 months, borrowers were able to take advantage of already low rates and consequently may have less incentive to refinance now when compared to loans originated in the earlier years.

Over the last year, our agency portfolio demonstrated the value of asset selection, which has resulted in low portfolio CPRs in the range of 4% to 7%. That trend continued this quarter with a portfolio CPR of 4.4% versus CPRs of 26% on the Fannie Mae 4.5% universe.

For Arlington, the concentration of our portfolio in prepayment-protected mortgage-backed securities below CPRS has a significant positive impact on the consistency of our asset yield and spread income as well on the preservation of book value.

Prices for assets with these particular characteristics have risen sharply as the positive impact of the prepayment performance has become apparent. As our agency assets have appreciated, we have selectively taken the opportunity to further improve our asset profile as well as expected CPR performance and resulting spread income from the portfolio.

Some of this portfolio management occurred in the second quarter and resulted in net cash gains of $1.4 million. Further price escalation post quarter-end has given us the opportunity to make additional portfolio adjustments, which have resulted in realized cash gains of approximately $5 million in the third quarter today.

The futures contracts were utilized to hedge our agency portfolio to run consecutively on a quarterly basis beginning in mid-December 2012 and extend out to June 2017. They have an average notional amount of approximately $823 million. Based on book value per share of $22.58 at June 30, 2012, the mark-to-market average cost over 5 years of the hedge was 1.07%.

A fully-hedged portfolio such as ours will have divergences of value between the hedged position and the underlying mortgage-backed securities. Therefore, while we have structured debt portfolio to achieve attractive spread returns over time, we expect to experience unrealized mark-to-market gains or losses in the course of achieving those returns.

Late in the second quarter, the strong European risk-off driven rally and interest rates and expansion of spreads resulted in a 57% -- $0.57 per share unrealized mark-to-market adjustment in the agency portfolio for the second quarter.

In the third quarter, upward asset price movements reversed nearly all of the adjustments shortly after quarter-end. With an expected agency mortgage-backed security asset yield of approximately 3.2% and approximate average annual hedge cost of 1.07% over 5 years, assuming leverage of 8:1 on an invested capital of about $110 million, the annual expected return on equity from the agency portfolio would be in the high-teens on a hedged basis.

Expressed this way, using the average hedged cost over its 5-year life, the economic earnings going forward on a per-share basis would be approximately 16% per quarter lower than core operating earnings per share in the second quarter, or $1 per share.

We have also seen encouraging news regarding our private-label portfolio as the housing industry and mortgage data have shown stabilization and in some MSAs improvement. The trends in our portfolio have been steady with improvements in serious delinquencies, CPRS and loss severities. In 2012, we have observed more consistency to these trends than in other postcrisis periods.

At June 30, 2012, our private-label portfolio had a fair value of 64% of face value, total market value of $173 million and a repo of $35 million. OCI related to the private mortgage-backed securities was $34 million as of June 30. The assumptions used to value the portfolio at June 30, 2012 included a weighted average -- on a weighted average basis, a constant default rate of 5.4%, loss severity on the liquidated loans of 44%, constant prepayment rate of 15% and a discount rate of 8.4%.

During the second quarter, the company recorded $4.5 million of non-cash GAAP charges for OTTI on 5 non-agency bonds, representing a reversal of the cumulative non-cash discount accretion previously recorded on the bonds. This charge is noncash and does not affect core operating earnings or book value, but does lower the accounting basis used to record future discount accretion, which should more closely reflect future cash flows.

As the company's net interest income and cash earnings have expanded from the deployment of the offering proceeds at attractive spreads, in the future, we expect to monetize more of the company's net operating loss carry-forwards, converting potential future value to current cash for shareholders.

As of June 30, 2012, the company's net capital loss carry-forward was $390 million with a final expiration of 2015. And the company's net operating loss carry-forwards of $270 million with a final expiration in 2027. We are optimistic about the company's opportunities. We have 2 complementary portfolios with attractive attributes, high risk-adjusted returns that permit the company to generate consistent cash earnings and dividends with the potential for growth.

While agency prices are high and reinvestment spreads have narrowed slightly, our assets are performing very well, hedged costs are low and the investment environment continues to be attractive. And for private-label mortgage-backed securities, credit trends have improved. And we continue to see investment opportunities with expected loss adjusted yields solidly in double digits with current cash yields in the high-single digits.

Operator, I would like to now turn -- open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jason Stewart with Compass Point.

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

A couple of questions. Is it your intent, given the high dollar prices of the securities you own and clearly, they've performed well, to rotate out of more of those? Or is that $5 million gain the extent of the portfolio management you want to make in the third quarter?

J. Rock Tonkel

I think it's opportunistic, Jason. We've seen opportunities to take advantage of certain situations to what we think has upgrade the performance to the assets. And if we see those opportunities going forward, we'll continue to do some of that. I think we don't have a particular plan right now to do it. We're taking it opportunistically, and we've had an opportunity to do that nicely in both the second quarter and the third quarter to-date.

Eric F. Billings

So -- but clearly, Jason, at the end, the portfolio is a spread-based portfolio, and it's not -- it's very secondary and it is really the gains come really as a function of being able to optimistically reposition the spread character of the portfolio so that it will be enhanced over a long period of time. That particular perspective has not been altered.

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

What would you -- what's the spread characteristic of new investments that you would be redeploying into? Any color you could give us there?

J. Rock Tonkel

I think, Jason, it matches what we -- what Eric said in the script. I think he characterized the yield at current market prices would call it at 7 CPR -- 7 to 8 CPR assumption on it to be in the neighborhood of 3 20 on the assets we're seeing and investing in and on the other side, the hedged costs to be a shade -- right around 100 basis points.

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

Okay, that's very helpful. And then on the OTTI adjustment, was there any primary driver, or was it a confluence of factors that reversed out that discount accretion?

Kurt Ross Harrington

Yes, Jason, it's Kurt Harrington. It just -- it isn't any one particular thing. It's just the fact that under the accounting rules, you have to accrete at a historical IRR. You're not allowed to adjust that down. So when that accounting basis rises above the fair value, you take the basis down so that going forward, that accretion will be closer to the cash. So it's just nothing in particular. It's just something given the accounting method that I think you're going to see more of.

J. Rock Tonkel

As you know, Jason, for core purposes, we exclude the non-cash income from the non-agency portfolio in any event.

Jason Stewart - Compass Point Research & Trading, LLC, Research Division

Right. And one last question on the theme of core income. I appreciate the disclosure about removing some of those one-time or, I guess, nonrecurring costs. Would all those be related to the Wells notice? If not, could you break it out or maybe give us any update on that and costs associated with it?

J. Rock Tonkel

No real change there. I just -- that activity fluctuates. And there's a little more of it in the first quarter, although less of it in the second quarter. And until it's completed, there will be -- we expect that, that will be an ongoing level of that. What that will be exactly? We can't be clear on. And -- but I don't think anything -- I wouldn't comment that anything significant has changed there.

Operator

Your next question comes from Jim Fowler with Harvest Capital.

James J. Fowler - Harvest Capital Strategies LLC

A couple of housekeeping to start, what -- shares outstanding at the end of the quarter were how many please?

Kurt Ross Harrington

9,790,000.

James J. Fowler - Harvest Capital Strategies LLC

On the balance sheets, the -- I'm assuming the securities sold receivable of $70.7 million and the securities sold not yet purchased on the liability side and $70.9 million. Do those match up?

Kurt Ross Harrington

Yes, they do.

James J. Fowler - Harvest Capital Strategies LLC

Okay, great. Just a quick question on the investment loss, gain in the -- I'm trying to make a guess here at the component parts. The derivative liability from the first quarter went up about $18 million. So I'm assuming that the -- and the deposit went about $18 million. So I'm assuming that the futures mark was about $18 million negative. So that means the MBS portfolio was gained in appreciation by about 10%. Is that the right way to think about it?

Kurt Ross Harrington

12%. Yes, 12%.

James J. Fowler - Harvest Capital Strategies LLC

Okay, got it. Perfect. And then -- let's see, the -- oh, I'm sorry, I'm sorry. The $5 million gain in the third quarter that you've taken, what's the par value that, that if sold would result in the $5 million gain approximate?

J. Rock Tonkel

No, it would be probably neighborhood of $100 million.

James J. Fowler - Harvest Capital Strategies LLC

Okay. And the yield that was sold versus -- I think you gave me -- you gave us the 3 20 reinvestment but the yield that was sold was about how much?

J. Rock Tonkel

I'm sorry. Jim, the yield on the assets that we sold in the second quarter or third quarter?

James J. Fowler - Harvest Capital Strategies LLC

The third quarter. The $100 million that you sold, I'm just wondering what the...

J. Rock Tonkel

They're consistent with the asset profile that Eric spoke to in the script. I mean, they're generally going to be consistent with the overall portfolio yield. It's just -- it's just the opportunistic pruning and upgrading of our relative value in the portfolio from a CPR and expected spread income perspective.

James J. Fowler - Harvest Capital Strategies LLC

Got it. So we shouldn't see any reasonable change in the margin on the reinvestment...

J. Rock Tonkel

Nothing material in terms of a change there.

James J. Fowler - Harvest Capital Strategies LLC

Okay, great. 2 more questions, if I might. The -- I think -- I was taking notes on the script, a lot of good detail this time. But I think you mentioned that 53% of your agencies were HARP?

J. Rock Tonkel

Yes.

James J. Fowler - Harvest Capital Strategies LLC

Okay. So the 47% that's not HARP, what's the wallet on those bonds, please?

J. Rock Tonkel

The overall wallet is about 12 in the portfolio.

James J. Fowler - Harvest Capital Strategies LLC

And in the non-HARP, is that -- would that be substantially less than 12?

Kurt Ross Harrington

I don't have the number off the cuff, Jim. But I don't think it would be substantially different. If it is, I will come back to you with it.

James J. Fowler - Harvest Capital Strategies LLC

Okay, great. And then, the last question. On the $5 million OTTI, this -- I mean, your statement that the accretion was greater than the cash coming in. I mean, that would tend to lead me to believe that some of the liquidation values of the underlying assets were at higher severities than were estimated in your level 3 assumptions. I mean, how -- what are you seeing? And I guess, you're not seeing any further deterioration. You've taken a larger charge but I guess, what I'm wondering is how do you monitor that? I mean, how fluid could that be?

J. Rock Tonkel

Well, first of all, keep in mind, we don't recognize the non-cash income that was reversed in the first place so -- for core operating earnings. So it's sort of bookkeeping in the sense, but it's important bookkeeping because it's GAAP. But for core cash earnings, the way we express it, we exclude it anyway. And we -- as I think you could probably judge from all of our historical commentary, we continue to assess these bonds as intended to require to on a bond by bond basis, and we monitor all manner and all features of these bonds consistently in terms of delinquency levels, delinquency migration rates, severity rates, et cetera. And I don't think -- and I think we spoke to what we see in terms of the underlying asset performance. We spoke to underlying asset performance in the release and in the script in terms of the trends we're seeing, which are generally steady with elements of improvement in all the major categories. I think Kurt, in his description of the OTTI, hit an important point, which is that because of the way these rules prescribe the recognition of GAAP income for non-agency assets, you're held to and that is the highest ever threshold of performance for every given asset. And the asset -- the cash flows from these assets, as you know, Jim, are variable. Month-to-month, quarter to quarter, there can be more prepayments or less prepayments. And so there is maybe a tick higher or tick lower. So they are variable and yet the prescribed rules don't sort of want to take that in -- fully into consideration in essence. And so you sort of have to operate within that constraint from a GAAP perspective. But for our part, we don't -- we exclude that for core operating earnings anyway. So we think of it as a side issue.

James J. Fowler - Harvest Capital Strategies LLC

Yes, I'm just wondering -- my question there is what I'm -- I guess, I'll just ask directly what I'm trying to jot down. I mean, you've got your fair market value of just under 64%. I'm looking at that portfolio and wondering what portion of that 36% discount is credit related that we might recover into the value of those securities as time goes on, if the markets misjudge the credit performance specifically?

J. Rock Tonkel

If you look at the statistics we provided, here's a back of the envelope way to do it. It's not perfect and it's not applicable to every bond. But as an overall look at the portfolio, it captures the essence of the answer to the question. Today, that portfolio has about 19% serious delinquencies. And it has loss severities of about -- for the last quarter 48% -- 48% coming down a little bit. So if you said you thought that loss severities were going to be 45% to 50%, then you'd expect on that block of serious delinquencies, assuming they all liquidated, which I think increasingly that's not the case, and increasingly there are cure rates and many of these bonds are increasing among the serious delinquency buckets. And that's part of the reason for the improvement in the serious delinquency levels, not all of it but it's a part of it. I would say if we're 19% and you call it a 45% in terms of severities, then basically what that would say is you'd expect to have about 9.8, 8 points of loss from that portfolio from the existing block, right? And if you have a 6% enhancement, that would say you'd expect to lose about 3 points, ultimately of principle from those bonds versus par of 100. And then, you'd say, "Well, given the rest of the assets, the 80% that are current, much -- most of those have been a large segment. If not, most of those have been always current." So you'd have to make a judgment where you thought the migration rates are from there. But it points to the essence of the question, which is that if the bonds are at 63 8 [ph] and the loss that you'd expect to take with no cure on the serious delinquencies would be something like around 3, maybe 4 points. Then, you've got between 64 and something like 96 to absorb whatever follow-on credit migration there'd be to serious delinquency and ultimate liquidation in this economy with these borrowers that are now basically 5 years, 6 years, 7 years seasoned in these portfolios. So in this rate environment, with this jobs market, you make your judgment on that and you deduct whatever you think that loss amount using your 45 severity would be from 96. And that gives you your potential upside in the asset from a credit and from a risk spread compression perspective as well.

James J. Fowler - Harvest Capital Strategies LLC

And then last detail, just from the script. Did you say that you have $823 million per quarter of futures outstanding to June 2017? Is that the right note?

J. Rock Tonkel

Yes, and that's sort of back-end weighted, right? Because we're not as -- we're not hedged in the rest of '12 and we're a little less hedged in '13 than we are in the later periods. So it's back-end weighted.

James J. Fowler - Harvest Capital Strategies LLC

Well, and that's -- one last question. How would I relate 2013 to 2014? I mean, what percent -- I mean, if nothing happened, what percent are you less in 2013 than, say, 2014 and forward?

J. Rock Tonkel

5% to 10%.

Operator

[Operator Instructions] Our next question comes from David Walrod with Ladenburg.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

I think pretty much -- most of it have gone through. Just a couple of housekeepings. Where are we, Eric, with your stock sales? Was there much rubbed in -- I mean, overhang that you completed most of that?

Eric F. Billings

I haven't even looked at that. I think we have completed a lot of it. And we've got probably...

Kurt Ross Harrington

[indiscernible] 12.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

I'm sorry?

Eric F. Billings

Yes, yes. Basically almost 12, that's the hedge fund. So there's probably about 1/3 to go.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

1/3 to go, okay.

Eric F. Billings

But then again, we -- but yes, 1/3 to go.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

And [indiscernible] alluded [indiscernible] an update for the Wells notice?

J. Rock Tonkel

No.

David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division

What about the Virginia Tech situation?

J. Rock Tonkel

No change.

Operator

Our next question comes from Jim Fowler with Harvest Capital.

James J. Fowler - Harvest Capital Strategies LLC

A one quick follow-up. From the first quarter to the second quarter, your professional services went down about $600,000. Is that a good number for the next couple of quarters at the 600-- the 900,000, do you think?

Kurt Ross Harrington

Well, the -- I think the ongoing type of legal expenses were probably 200 or 300. And so the other part is lumpy based on these matters that we've talked about.

Operator

And at this time, we have no further questioners in the queue.

Eric F. Billings

Thank you very much, everybody, for joining us. And we look forward to speaking with you all next quarter. Take care, everybody.

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