Rob Grien - President
Rich Smith - Chief Financial Officer
Aaron Peck - Managing Director and Senior Portfolio Manager
Scott Exide - Financial Relations Board
Alex Entevy - GV Capital
Tim Windon - Deutsche Bank
Tayo Okusanya - UBS
Douglas Harter - Credit Suisse
Deerfield Capital Corp. (DFR) Q1 2008 Earnings Call May 13, 2008 11:00 AM ET
Good day and welcome to the Deerfield Capital Corp first quarter 2008 conference call. Please be aware that today’s conference is being recorded. At this time I would like to turn the conference over to Mr. Scott Exide of the Financial Relations Board; please proceed.
Thanks operator. Good morning everyone and welcome to Deerfield Capital Corporation’s first quarter 2008 conference call. The earnings press release was distributed on Monday, May 12 after the market had closed. In the release the Company has reconciled all non GAAP financial measures to the most directly comparable GAAP measure influenced of Reg E requirements.
If you don’t receive a copy these documents are available on the Company’s website at www.deerfieldcapital.com, under press releases. Additionally, we are hosting a live webcast of today’s call which you can access under the header ‘Investor Relations.’ Following the slide call an audio webcast will be available for one month on the Company’s website at www.deerfieldcapital.com under the same header.
Management will provide an overview of the quarter and then we’ll open the call to your questions. Before we begin management would like me to you inform me that certain statements made during this conference call which are not historical may constitute forward-looking statements within the meaning of the Private Securities Litigation Reformat Act of 1995.
Although Deerfield Capital Corporation believes the expectations reflecting any forward-looking statements are based on reasonable assumptions. They can give no assurance that its expectations will be attained. Factors and risks that could cause actual results of different materially from those expressed or implied by forward-looking statements are detailed in today’s press release and from time-to-time in the Company’s filings with the SEC.
The Company does not undertake a duty to update any forward-looking statements. Additionally, we wanted to remind participants that the information contained in this call is current only as of the day of this call May 13, 2008 and the Company assumes no obligation to update any statements, including forward-looking statements made during this call. Listeners in any right way should understand that the passage of time by itself will diminish the quality of the statement.
I would now like to introduce you the Jonathan Trutter Chief Executive Officer of Deerfield Capital and I’ll turn the call over to him for his opening remarks. Jonathan please go ahead.
Thank you Scott. I would like to welcome you to today’s call and thank you for your participation. Joining me today from the Company are Rob Grien our President; Rich Smith, our CFO; Aaron Peck, Managing Director and Senior Portfolio Manager of DFR and several other members of Deerfield senior management team. We appreciate you joining us today.
As we reported on our last conference call in early March and the follow-up on the press release of March 14, the first quarter of 2008 was characterized by a meaningful acceleration of the deterioration of the credit market that began in late 2007. This deterioration resulted in a material down sizing and more importantly delivering of our balance sheet which resulted in the realization of significant losses in our mortgage portfolio.
Rich will spend more time in a moment reviewing the components of the losses, but in some they resulted from a vicious cycle of lower access to financing, restore graph and delivering of investment positions, the combination of which contributed to accelerated declines in asset prices and higher financing costs.
On April 25, we reported that DFR had improved its liquidity with cash on cumbered liquid securities and net equity and financed liquid securities of approximately $91 million as of March 31. It’s important to note that our portfolio fixed income investment generates a positive stream of cash flow and therefore we would expect our liquidity to continue to strengthen with time ending redeployment of our capital in the future.
While the financial markets remains skittish it appears that that actions in concert with other central banks around the world have significantly improved near term liquidity in the system. As we previously reported we sold agencies securities with an amortized cost of approximately $4.6 billion and AAA rated non agency securities with an amortized cost of approximately $1.6 billion in the first quarter. Our current agency footings are approximately $438 million and our AAA rated non agency footings are approximately $30 million.
We also reduced our net notional swap exposure by approximately $6.2 billion leaving us with approximately $525 million of notional swap exposure. The duration of the portfolio is approximately 1.2 years based on model driven modified duration results, however based on actual price movements observed in the market we believe the incurred duration is actually close to zero.
We believe that as of today we have a well hedged and attractively earning RMBS portfolio and spreads in this portfolio have tightened since quarter end in response to the improving market liquidity. In addition to the sell down of the RMBS portfolio we selectively reduced our alternative asset holdings. In our corporate leverage loans and commercial real estate portfolios our assets declined in the first quarter by approximately 9% to $430 million reflecting refinancing as well as selective sales made in order to further enhance liquidity and to reduce the portfolios exposure to corporate credit and commercial real estate during these volatile times.
The acquisition of our external manager, Deerfield Capital Management which I will refer to as DCM was completed at the end of December and the first quarter represents the first recording period with the full quarter of DCM results. Many investors have request in greater transparency on DCM’s operations and we have tried to accommodate that request in our Form 10Q that was filed last evening.
We continue to believe that the acquisition of DCM transformed DFR positioning it for a much higher growth potential than DFR’s prior investment strategy. Despite the difficult market conditions DCM has been able to maintain relative stability in its assets in our management. At April 1, DCM had assets in our management of $14.2 billion which is only slightly lower than the $14.5 billion we managed as of January 1. We remain confident in the core strategy behind the merger with DCM; mainly the completing of our principle investment revenues with fee based revenues. Going forward our principle investing will be concentrated towards providing fee capital for new products managed by DCM.
I will first discuss our growth strategies in a minute but I want to address our cost based and elaborate on our most valuable assets; our people. In concert with the more challenging financial environment we have aggressively addressed our expenses. Since August of 2007 DCM has modified its employee base resulting in approximately annualized cost savings of $6.7 million.
One of the attractive aspects of our business model is its scalability while our current staffing levels are appropriate for the prudent maintenance of our current level of assets on our management. We have the flexibility to implement our near term growth plans without adding significant staffing costs. Importantly we have maintained the senior management in our key business units and we expect to implement programs and set it to retain inside our high quality work force.
While no one here would understate the negative impact of the recent unprecedented global market dislocations on DFR; our survival has been a significant accomplishment. Management is not looking back and wondering what might have been. Instead if the markets are stabilized we began to focus on future growth as opposed to near term liquidity issues. It’s a compelling opportunity and we look forward to reporting on our progress in future quarters as we rebuild value for share holders.
The DCM platform is time tested and has impressive multi year track records in many of our business lines. Our ability to adapt our areas of expertise to new products and structures reflective of the current markets will define the new Dearfield. In the near term we will be focused on three primary growth initiatives: first, we look to acquire CDO contracts from managers that have not previously achieved critical mass and may be looking to exit the CDO business. We currently have identified several CDO management contract acquisition targets, some of which are currently in documentation.
We believe this is a profitable strategy and will allow us to opportunistically take advantage of current market conditions. This strategy demonstrates the scalability of the DCM platform as we believe we can absorb billions of dollars of new portfolios without adding significant incremental cost.
Secondly, we look to expand our core 16 come expertise in the new non CDO vehicles. The goal here is to increase third party management fees in new products preferred by investors and can ultimately increase the ROE of the firm. Finally noting that consolidation is a growing theme among assets managers we will opportunistically look to add teams with expertise not currently resident at DCM in order to expand our menu of related product offerings.
In summary the financial markets have endured a series of negative events since August of last year. All these events and particularly those in the first quarter have had a profound negative impact on our Company and our share holders. We believe we have the foundation of people and expertise to grow rapidly and profitably in the years to come. We are excited about that future.
Now I would like to turn the call over to our CFO Rick Smith for a more detailed discussion on the first quarter financial results Rick.
Thank you, Jonathan. DFR reported a first quarter GAAP loss of $463.6 million. Estimated re-taxable income, a non GAAP financial measure was a loss of $16.4 million for the quarter or $0.30 per share. The GAAP loss was primarily driven by five major items: first, realized losses on sales of AAA rated RMBS totaled $193.5 million in the quarter; second, we had net losses in the undesignated pay fixed interest rate swap portfolio of $127.6 million due to following swap rates during the quarter; this portfolio is used as an economic hedge over the RMBS portfolio.
As we previously disclosed we have a long standing practice of hedging a substantial portion of the interest rate risk in financing the RMBS portfolio. This hedging is generally accomplished using pay fixed interest rate swaps as the credit environment worsened in early 2008 creating a flight to US treasury securities in prompting further Federal Reserve rate cuts; interest rates decreased sharply. This caused losses in the swap portfolio but also required us to post additional collaterals to support these declines.
While agency issued RMBS demonstrated offsetting gains providing release of certain margin AAA rated non agency RMBS experienced significant price declines which coupled with losses on our interest rates swap portfolio exacerbated the strain on our liquidity.
Third we accelerated the amortization of deferred, designated, interest rate swap losses totaling $91.7 million in the quarter. These losses first arise when designated interest rate swaps are either terminated or de-designated; hedge accounting ceases at that point and the amount in equity in the other comprehensive income section is frozen and then amortized over the original life of the swap.
Since we sold a significant portion of RMBS portfolio in the first quarter we could no longer justify continuing to take care the entire amount of loss deferred in equity. Accounting rules require that we -- that nearly the entire deferred amount be charged to the income statement. This charge does not impact book value since $97.2 million of swap losses were already deferred in the other comprehensive income section of equity at year end. The deferred loss remaining in equity from hedging activity is just $335,000 at March 31.
Four, $27.9 million of impairment charges on good will and tangible assets were recognized in the quarter. The carrying value of good will and intangible assets is down to $151.6 million at March 31 compared to $181.9 million at year end. These assets were created at the time of the acquisition of DCM. The impairment of good will was triggered by the first quarter decline in market capitalization of the Company.
The intangible asset impairment is due to the April 30 liquidation of the smaller of our two investment hedge funds and the liquidation of a euro denominated CLO. As of April 1, the assets under management of the liquidating investment fund totaled approximately $98 million and the liquidating CLO totaled approximately $645 million.
We continue to believe the prospects for the asset manager remains positive, consistent with the outlook at purchase. Lastly, the corporate bank loan book in our markets quest CLO was marked down by $18.7 million in the first quarter as wide spread risk aversion in the credit markets drove down prices in this portfolio. As you may recall DFR consolidates both the assets and term funding for markets square. While we marked the loans in the portfolio to the lower cost or market there is not an offsetting right down of liabilities. $7.9 million of this write down is an uneconomic charge to earnings since that is the amount of negative equity in market square that is flowing into our financial statements even though our exposure in this bankruptcy with no entity is limited to our equity investment.
To date market square has returned $17.2 million in dividends on the original investment of $24 million. The portfolio has experienced a relatively low default rate since inception and we note that bank loan prices in general have improved materially since quarter end. Several items provided a partial favorable offset including the following: sales of agency RMBS generated net gains of $24.4 million.
First quarter investment advisory fee is a total $12.1million. Please note that upon our January 1 adoption of financial accounting standard number 159 know as the fair value option we are now carrying the RMBS and associated interest rate swap portfolios at fair value adjusted through the income statement. This decision was made primarily to eliminate the operational complexities of applying hedge accounting.
We recorded a net provision for loan loss this quarter of $2.2million. This charge reflects an additional probable loss on a previously identified impaired loan to a company serving the housing sector that we are now carrying at $0.25 on the dollar. We have just this one impaired loan in the held for investment loan portfolio. Total invested assets decreased by $4.9 billion during the quarter reflecting our actions to enhance liquidity, the most significant decreases were in government agency RMBS of $4.2 billion and triple AAA rated non-agency RMBS of $1.6 billion.
Asset under management totaled $14.2 billion generating the previously mentioned investment advisory fees of just over $12 million in the quarter. Approximately 65% of these fees are for managing CDO’s and approximately 33% from our investment funds. Estimated re-taxable income was a loss of $16.4 million in the first quarter, the taxable results were primarily driven by amortization of net losses on terminated swaps designated as tax hedges which total $20.9 million in the first quarter. We expect amortization of swap losses of approximately $22 million to $30 million per quarter for the balance of 2008.
We currently have estimated undistributed taxable net income carry forward from 2007 of $7.6 million which would have to be distributed in 2008 to avoid taxation at the corporate level on the undistributed amount and now I would like to turn the call back to Jonathan.
Thanks Rich. At this point we’d like to open the call up for questions.
(Operator Instructions) We will take our first question from Douglas Harter with Credit Suisse.
Douglas Harter - Credit Suisse
Hi thanks. I was wondering if you could talk about your strategy to maintain recent plans given that you sold the Treasury bill.
Yes thanks Doug. We have maintained our status using the T-bills. We want to also make sure that we understand the issues related to alternative non-restructures but at the time at 03/31 there was still considerable volatility in the financial markets including mortgages, so while we were considering an entry point for reinvesting in mortgages the T-bills strategy seemed to be the most efficient way to address the re-compliance in the near term. Going forward we think we can maintain compliance with the asset test by either adding so called good assets or decreasing so called bad assets, but given our goal to maintain the liquidity and flexibility, we didn’t want to lock ourselves into a specific strategy at quarter end.
Douglas Harter - Credit Suisse
Right thanks and then I was just wondering sort of on the liquidity front if you could talk about sort of what’s happen with the Wachovia Facility sort of after quarter end and sort of the plans to sort of get the leverage down in that facility.
Thank you for that Doug, can you repeat the question?
Douglas Harter - Credit Suisse
Sure, so if you could talk about to the -- so what’s going on with the Wachovia Facility post quarter end and sort of plans for getting the loans down or the out standings down in that facility.
Yes, Wachovia didn’t renew the facility. I think there was disclosure on that in the Q and frankly that wasn’t a surprise to us; I think we’ve telegraphed that on prior calls and in fact we haven’t utilized the facility to make any new investments in quite sometime, so we’ve been positioning ourselves for this possibility for a while. Wachovia is currently trapping interest in principal pay downs from the underlying portfolio to pay down the warehouse. We have a reasonable amount of visibility on some of the credit cards, where nothing is guaranteed, but we see a pretty reasonable glide slope to get the facility paid down to a level that is comfortable and in the medium term and in addition we are selectively working out some trades involving assets in the portfolio to further reduce the exposure if possible.
Douglas Harter - Credit Suisse
And what would the final maturity of that facility be or by now will it have to be completely shut down by?
Well, currently we have an agreement with them that is -- it’s a little open ended, but we believe we have well into September in the near term to get it down but we believe that we’ll get extension beyond that.
(Operator instructions) We’ll take our next question from Tayo Okusanya with UBS.
Tayo Okusanya - UBS
Yes, good morning. Just a little more in regards to DCM and you did give quite a lot of detail in your commentary about ways you are looking to grow that business. I guess could you talk a little bit about just how quickly you expect your strategy to take footing and just what kind of interest you are seeing from investors who are possibly looking how to use the DCM as their third party asset manager.
Great thanks Tayo. As for speed I think that is dependent upon the particular strategies; for example, the CDO strategy where we are looking to acquire additional contracts that can be done in a matter of months, easily less than six months to go from start to finish on that; although many of them require some note holder consent. So that can be done as I said in a matter of months. Some of the longer term strategies, the partnership strategies or hedge fund strategies, they will take more time to cultivate their higher margin business, so that’s typical for that niche in the business place. I think as in terms of receptivity I think we have established some significant track records in a number of our business lines that gets us a good call into potential investors, so longer term we are very encouraged about that.
Tayo Okusanya - UBS
Okay that second question; at what point do you think you might actually be able to start to actively grow the principal investing business again. The Wokovia line is down; I’m not sure what’s your ability to raise capital at this point; how do you think about that side of the business going forward?
Well it’s related to DCM in terms of some of the growth strategies we have unidentified at DCM, some of the fund strategies, we use principal investments to feed those strategies. It’s also a factor of liquidity. As we feel more comfortable that the markets have stabilized then we will be more active in deploying our capital.
Tayo this is Aaron, just to be clear and to amplify what Jonathan was saying; I don’t think we are going to turn on the principal business the way that you knew it when -- at the inception of the firm. We’ve changed the focus of what our principal business means to us as we acquired DCM and as our capital base unfortunately is shrunk, so we really view our capital -- our principal investment business as us providing capital to feed products to grow our asset management business and frankly it’s a much higher ROE calculation anyway in terms of the long term future ROE of the business.
(Operator Instructions) We’ll take our next question from [Tim Windon] with Deutsche Bank.
Tim Windon - Deutsche Bank
Hi good morning. I was wondering if you guys could talk about the bank loan market right now and sort of what you guys expect losses to be for ’08 and ’09 and how you see credit in the bank loan market playing out?
Great thanks Tim. Clearly we would expect to see some increase in default rates overtime; I think that’s the consensus of the market. It’s unclear how dramatic that would be. I would say as it relates to Deerfield strategy in the bank loan space not just in market square but for the other portfolios that manages. We’ve always been focused on credit quality as opposed to yield in the portfolios, sort of an all whether approach, so we designed the portfolio so that they can handle a more restrictive of credit environment without sacrificing performance, so while we recognize the market in general may have a tickup in the default rates; it doesn’t necessarily translate into worst performance for DCN managed accounts. The market in general continuous to be challenging in terms of new deal volume and particularly its relates to the securitization market, but longer term we believe that CLOs will continue to be a liable financing technology and it may not happen near term, but longer term we believe in that fact.
Tim Windon - Deutsche Bank
Great thanks. What about recovery rates on bank loan; do you see that changing lot in the next year or so as the markets grappling with higher defaults?
I think it’s sort of a case-by-case and anytime you deal with credit -- I think recovery rates on the traditional senior secured market, I think depending on credit selection will hold their own. I think on curvy light structures and on second lien structures where the bank loan was really subordinated in the transaction I think that will be a more challenging issue for bank lenders overtime. As an institution we’ve had a very low exposure to that part of the market.
We’ll take out final question from [Alex Entevy] with GV Capital.
Alex Entevy - GV Capital
Hi gentlemen; a question on yes management business. Can you give us some color on what lengthier contracts are to manage CDOs and bank loans or asset backed securities in general if we were to put a duration on the overall portfolio of your fees, what would those be?
We have a -- alright this is Aaron Peck. We have a comprehensive break out of the call dates and the reinvestment period termination and the maturity date on a deal-by-deal basis for our managed CLOs and CDOs in our 10Q that we filed last evening, it’s on page 55; so you can go through that and look at that and you’ll see the maturity dates range for example in the CLO market -- our ClOs range from 2009 on the very short end, all the way up through -- I’m just looking 2023 in terms of maturity dates and so its quite a bit of length on the maturity of those portfolios. There is a shorter reinvestment period which varies portfolio-by-portfolio. On the ABS TDO’s the maturity date is quite a bit longer in general and averages out from sort of 2032 out to even beyond that. So there is pretty long maturities and the reinvestment periods are shorter on some of those and you’ll see if you look at that on a day-by-day basis, and once you’ve done that if you have specific questions you can feel free to call back, so we can clarify.
Alex Entevy - GV Capital
Appreciate it. I suppose just a quick follow up would be if you could talk a bit more about you cost cutting programs and whether there is -- we should some further cost cuts going forward from the ones you have already mentioned today.
I think that our cost cutting to date has been commensurate with what we have seen the near term business environment to be like. I think we’ve got a strong franchise here. So we have adapted our cost structure to be in a position where we can maintain the business we currently have, but yet also be in position that we have sufficient infrastructure to grow the new initiatives, so I think we are in relatively speaking an attractive position right now.
And we have no further questions. At this time I would like to turn the conference over to Mr. Trutter for any additional or closing remarks.
Again I thank everybody for their participation and I look forward to next quarter’s call.
Thank you ladies and gentlemen. Once again that does conclude today’s conference and thank you for you participation.