Hannah Rutman - Investor Relations
Gary Kain - President & CIO, American Capital Mortgage Investment Corp. &
President, American Capital MTGE Management, LLC
Jeff Winkler - SVP & Co-CIO, American Capital Mortgage Investment Corp; and SVP, American Capital MTGE Management, LLC
Peter Federico - SVP & CRO, American Capital Mortgage Investment Corp; and SVP & CRO, American Capital MTGE Management, LLC
Chris Kuehl - SVP, Agency Portfolio Investments, American Capital Mortgage Investment Corp; and SVP, American Capital MTGE Management, LLC
Douglas Harter - Credit Suisse
Joel Houck - Wells Fargo
American Capital Mortgage Investment Corp (MTGE) Q2 2012 Earnings Call August 6, 2012 11:00 AM ET
Good morning, and welcome to the American Capital Mortgage second quarter 2012 shareholder call. All participants will be in listen-only mode. (Operator Instructions) After today’s presentation, there will be an opportunity to ask questions. (Operator Instructions). Please note this event is being recorded.
I would now like to turn the conference over to Hannah Rutman in Investor Relations. Please go ahead.
Thank you Valarie and thank you all for joining the American Capital Mortgage Investment Corp second quarter 2012 earnings call.
Before we begin, I’d like to review the Safe Harbor statement. This conference call and corresponding slide presentation contains statements that to the extent they are not recitations of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results may differ materially from those forecast due to the impact of many factors beyond the control of MTGE. All forward-looking statements included in this presentation are made only as of the date of the presentation and are subject to change without notice.
Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in our periodic reports filed with SEC. Copies of these reports are available on the SEC’s website. We disclaim any obligation to update our forward-looking statements unless required by law.
To view a webcast of the presentation, access our website mtge.com and click on the earnings presentation link in the upper right corner. An archive of this presentation will be available on our website and a telephone of this call can be accessed through August 21st, by dialing 877-344-7529 using the conference ID 10015856.
Participating on today’s call are Malon Wilkus, Chairman and Chief Executive Officer; Sam Flax, Executive Vice President and Secretary; Gary Kain, President and Chief Investment Officer; Jeff Winkler, Senior Vice President and Co-Chief Investment Officer; Peter Federico, Senior Vice President and Chief Risk Officer; Chris Kuehl, Senior Vice President in Agency Mortgage Investments; Jason Campbell, Senior Vice President and Head of Asset and Liability Management; and Don Holley, Vice President and Controller. With that I will turn the call over to Gary Kain.
Thanks Hannah and thanks to all of you for your interest in MTGE. We feel really good about MTGE’s performance both this quarter and since our IPO. During the quarter, MTGE was able to continue to pay an attractive dividend while growing book value for the third straight quarter. Economic returns which include both the dividend and book value growth equate to a 22% annualized return.
Since going public in August 2011, we have paid $2.80 per share in dividends and grown our book value over 10%. The combination of these two measure equates to economic returns of around 24% and it is not even been a full year. Over the same time period, MTGE has been able to grow its market cap from 200 million at the IPO to over 800 million as of today via two follow-on offerings that improved both operating efficiencies and the liquidity of the stock.
Importantly these offerings were executed in a manner that is supportive of shareholder value creation. We remain committed to exercising the same discipline going forward with respect to both equity offerings and the management of the business.
Looking ahead we feel really good about how MTG is positioned. The current landscape is one where interest rates were at rapid lows, the yield curve is considerably flatter and where many market participants starting to become more optimistic about the housing market.
Against this back drop of both our agency and non-agency assets should continue to provide attractive risk-adjusted returns across a range of different economic scenarios. Along these lines, performance quarter to date has been very strong. So we currently have a good tailwind behind book value at this point.
With that let's review the highlights for the quarter on slide 2. Net income which incorporates both realized and unrealized gains and losses on both assets and hedges was a $1.15 per share. Net spread income which excludes $0.35 of investment-related gains came in at $0.80 per share. The decline in net spread income during the quarter was a function of number of different factors including faster prepayment projections and higher swap costs, new purchases at lower yields and lower average leverage.
The bottom line though is the relative size of our mid-quarter equity raise does make quarter-over-quarter comparisons somewhat less instructive. Taxable net income totaled $0.89 on average shares of $28.1 million for the quarter. Now as you know we paid a dividend of $0.90 and since the dividend was paid on ending shares, our undistributed taxable income dropped to $0.11 as of June 30.
Book value increased $0.30 to $22.08 per share during the quarter. Again the performance of both agency and non-agency mortgages has been very strong so far in Q3 which in the absence of a large change in market conditions bodes well for the quarter.
The combination of the $0.90 dividend and the $0.30 increase in book value translated to a 22% annualized economic return. We feel really good about this result, especially during a quarter when we materially reduced our overall risk position and significantly increased the size of the company.
Now turning to slide 3. Our portfolio increased to $6.1 billion during the quarter, up from $4 billion at the end of Q1. Leverage declined during the quarter to 6.8 times from [7.86] times as of March 31.
MTGE’s average CPR remained below 5% for Q2 and rose to only 5.5% in the most recent prepayment release in July. However as a function of the declining interest rates our lifetime prepayment projections increased during the quarter from 7.3% to 9.5% CPR.
This speed adjustment coupled with purchases of assets of lower yields, higher edge cost, and higher repo rates let to a decrease in our net interest spread from 238 to a 194 basis points as of June 30.
Lastly as I mentioned earlier, we raised $322 million in new equity during the quarter.
So now let's turn to slide 4 and look at what happened in the markets during the second quarter. As you can see we had a significant rally in longer term rates during the quarter with the 10-year treasury dropping 56 basis points. The yield curve flattened materially as a two-year treasury rallied only 3 basis points.
Now as shown on the upper left, the prices of lower coupon mortgages also increased materially in response to the declines in interest rates while the price increases were more limited as you move to higher coupons.
15-year mortgages exhibited a similar trend that can be seen on the top right. Now with respect to risk assets, Q2 was relatively mixed with the S&P 500 and some other measures down during the quarter, but as Jeff will discuss shortly non-agency RMBS prices were up slightly.
Now let's turn to slide 5 and look at a high level overview of how MTGE’s capital is deployed at quarter end. As the table on the top shows, our portfolio remained heavily weighted toward agencies as of June 30. Chris will review the specifics of our agency portfolio, but it remains concentrated in lower coupon 30-year and 15-year mortgages with a high percentage of both lower loan balance and higher LTV loans originated under the HARP program.
We had about 17% of our equity dedicated to non agencies at quarter end and our non-agency portfolio continues to grow, but at a measured pace as we continue to be both patient and deliberate in our efforts to source value added assets.
Furthermore the odds of additional quantitative (inaudible) easing from the Fed have increased since last quarter and this has the potential of driving agency CMBS valuations considerably tighter despite a very strong year-to-date performance. If we do get a QE3 that incorporates substantial purchases of agency RMBS, we would expect to accelerate the migration of the portfolio away from agency’s securities as relative value would like deteriorate against that backdrop.
A key advantage of MTGE’s business model is its ability to play throughout the entire mortgage market giving it increased flexibility in this type of situation. And keeping our philosophy of active management and the liquidity of our agency portfolio, we would not hesitate to reposition the portfolio as market conditions change.
At this point I will turn the call over to Jeff, to discuss his views of the mortgage credit landscape and the non-agency portfolio.
Great, thank you Gary. So, turning to slide seven. Regarding the non-agency markets, there have been a couple of key things over the first half of the year. First, despite softer than expected macro economic data as it continues to show signs of stabilization. The prospect of home prices overshooting fundamentals to the down side has been mitigated a relatively slower liquidations coupled with investors buying homes to take advantage of rental yields, particularly in light of the sustained low interest rate environment.
As a result, some RMBS investors are starting to assign higher probabilities to the recovery scenarios and this has provided support to the market especially for sectors most levered to housing.
The second major theme has been favorable supply demand technical. The outstanding balance of non-agency is now less than 1 trillion and continues to shrink at about 50% per year mostly through liquidations. We have also seen key pockets of supply most notably from the Fed's main [line] portfolio absorbed into the market.
Further new money continues to be raised for this space from investors looking for yield and exposure to housing. Combining these conditions in non-agency market has had a [$1] for this time of the year and in July it extended gains further. The Third (inaudible) attracted fixed income asset is clearly helpful for the agency and non-agency markets and we continuously [assist] the related value and risk between the two sectors.
Our strategy around our main equity raised was similar to prior raises where we quickly deployed into agencies and add non-agencies overtime as we find simple assets. As of last weekend, our agencies are now about 20% of our equity allocations and we will look to increase this if agencies continue to perform well especially in light of any further (inaudible) we believe in.
Given current yield of the crop sectors, we find lower tier prime in all days to be the most attractive on our returns and equity basis. These sectors are up for attractive upside returns in bullish housing scenarios but also have stable cash flows and profiles. So leverage we are comfortable applying to each sector is the function of the yield profile across housing environment but it's also a function of the reality of the price or market value in extreme [risked] off environment which unfortunately we still cannot roll out.
Similar to our approach to agency investing, we are flexible in our strategy and we will adjust if pricing across these sector changes. With that I will turn the call over to Chris to highlight the agency portfolio.
Thanks Jeff. On slide 9 we have a graph highlighting the prepayment differences between the 30 year 4% passthroughs of the same vintage both of different loan attributes. You can see that both backed by loans with lower loan balances as well as loans that refinanced through the HARP program continue to perform extremely well relative to more generic TBA pass [throughs].
Keep in mind that rate levels are responsible for the July speeds in this graph, we are about 50 basis points higher than today’s rates and therefore we expect to see these prepayments speed differences continue to expand with TBA 30 year force likely paying well into the 30s and possible low 40s within a few months while lower loan balance on HARP securities will likely increase by only a few CPR. On slide 10, we have two hypothetical yield tables that illustrate the importance of prepayment speeds and their impact on returns.
In the table on the top half of the page, we are showing generic TBA 30 year force. At a 20 CPR they have an asset yield of 2.25% in this example. If we assume the cost of funds of 70 basis points that gives the net spreads of 1.55% and if we apply 7.5 times leverage that generates a gross ROE of 13.88%.
Now what would happen if prepayments speeds increase. At 30 CPR which is on the lower end of most of your forecast for where TBA force will prepay over the next several months, the asset yield drops to just 1.46% which leaves us with a net spread of 76 basis points and so with 7.5 times leverage, the ROE drops to 7.16%. Now on the table on the lower half of the page, we again showed 30 year force, however we are calculating the yield at a price of two points above the TBA price. This is roughly where some higher LTV HARP securities were trading as of June 30.
So the 7.5% CPR which is approximately where these securities have been paying, we have a gross ROE of nearly 19%. Even as speeds increase by five CPR which is beyond what we would expect in the current environment, the returns are still about 15% and very compelling relative to more generic TBA 30 year force.
So you can clearly see that despite the strong price performance of these strategies over the first six months of 2012, there were still a lot of value even as the higher payouts at the end of the quarter.
Given today's low interest rates and high dollar prices, prepayment fees are going to be a primary driver of performance. So this is probably a key reason why payouts on many categories of loan balance and HARP securities are up more than a half a point again since the start of the third quarter.
Let's turn to slide 11 to review the composition of the investment portfolio. So as rates rally during the quarter, pay ups on certain segments have specified core markets such as HARP and lower loan balance 30 year 3.5 [lag] the move lower and presented a compelling opportunity to increase our exposure to the sector.
You can see on the bottom on slide 11 that our lower loan balance HARP positions now represent approximately 80% of our 30 year holdings at approximately 71% of our total agency portfolio, but equally is important is that more than 95% of the portfolios other non-HARP and loan balance positions are invariable coupons, you can see a more detailed breakdown of these positions by coupon in the appendix on slide 28 where we give you the percentage of HARP and lower loan balance by coupon.
That will turn the call over the Peter.
Thanks Chris. Today I will review our funding and hedging activity. I will begin with our financing summary on slide 12. The cost of our repo funding increased six basis points during the quarter, at quarter end our average repo cost was  basis points up from 41 basis points the prior quarter. This increase was driven predominantly by a general increase in repo costs due in part to the incremental dealer balance sheet pressure created by the Fed's operation Twist.
The financing cost associated with our non-agency collateral was unchanged at about 2%. At quarter end, the average original days to maturity of our repo funding was 83 days, up slightly from 74 days the prior quarter. We will continue to carefully monitor our roll over risk associated with our repo funding and we will be opportunistic with regard to extending the average maturity of the portfolio.
A summary of our hedge positions is provided on slide 13 and 14. Slide 13 shows the detail associated with our swap and swaptions portfolios. Given the growth in composition of our asset portfolio, we increase the size and duration of our paid fixed swap portfolio. During the quarter, we added $1.1 billion of new paid fixed swaps bringing the total swap portfolio to $3.3 billion at quarter end.
These new swaps had an average term of 8.2 years and an average pay rate of 1.65%. Given the longer term of these swaps, the average maturity of our swap portfolio increased almost a full year to 5.8 years at quarter end from 4.9 years to prior quarter. Similarly, the average pay rate on the portfolio increased to 1.42% from 1.31%. Given the increase in our pay fix swap portfolio, our average swaps to debt hedge ratio increased to 63% in the second quarter from 58% the prior quarter.
On slide 14, we breakout our hedge positions, namely our treasury and mortgage hedges. Taken together, our total hedge portfolio which includes swap, swaptions, treasuries and mortgage hedges covered 77% of our debt balance at quarter end roughly unchanged from the prior quarter.
Before discussing our duration gap, I wanted to briefly review the counterparty credit risk associated with our swap and swaption positions. Over the current derivatives like swaps and swaptions expose us to counterparty credit risk. Importantly, there is no difference in the credit exposure created by a swap versus the credit exposure created by a swaption. A swaption is nothing more than an option on a swap and our counterparties have the same obligation to perform on a swaption as they do on a swap.
We manage the credit risk associated with these positions in two ways. First, we carefully select and monitor our counterparties. Second, as required by our derivative agreement, each swap and swaption position is mark-to-market on a daily basis.
Based on these marks, both we and our counterparties are required to exchange cash or securities each day thereby fully collateralizing the mark-to-market credit exposure associated with our swap and swaption positions. Through this continuous true-up mechanism our counterparty credit exposure is substantially reduced.
Turning to slide 15, we view our duration gap information. Due to the combination of falling interest rates and portfolio positioning, our net duration gap shifted to negative 0.5 years at quarter-end from a positive duration gap of 0.15 years for the prior quarter. This shift in our duration gap was driven by changes in both our asset portfolio as well as changes in our hedge portfolio.
During the quarter, the duration of our asset portfolio decreased to 2.9 years from 3.7 years as interest rates felled. The duration of our hedge portfolio decreased slightly to 3.4 years. Given the low level of interest rates and the potential extension risk in our mortgage assets, we believe to maintaining a negative duration gap was prudent from a risk management perspective.
And with that I will turn the call back over to Gary.
Thanks Peter. Let’s quickly turn to slide 16, so we can review the business economics of as of June 30th. The asset yield on the agency side is now 2.68% down 24 basis points from last quarter and that is a function of both the faster pre-payment projections we made, not the actual fees and the purchase of new assets at lower yields given the reality of the markets.
The larger change quarter-over-quarter was in our funding costs which rose 27 basis points of which around 6 basis points was higher repo with the remainder a result of our conscious decision to increase our hedges which Peter just discussed. The combination of these changes led to an agency net interest rate of a 171 basis points and when you apply leverage of 7.8 times and add-back the asset yield, you get a gross ROE snapshot of 16%.
On the non-agency side, the quarter-over-quarter changes were relatively small as pre-payment projections we’re hedging are non-agency. Our non-agency asset yield actually increased five basis points from 7.34% to 7.39%. Our funding cost increased to 182 basis points from a 157 basis points as a function of repo costs including some increase in the percentage of funding -- essentially some decrease in the percentage of funding essentially barred from agency’s portfolio.
Now after applying leverage and adding the asset yields, the gross ROE falls out just under 16% for the non-agency portfolio. In aggregate, the combination of the two sides of the business weigh to about 16% gross ROE. Importantly, our other operating expenses dropped materially as a function of our equity raises and is now 0.6% at the end of Q2 versus 1.9% at the end of 2011. In other words, they are less than a third of where they were initially after we went public.
Again, we are pleased to have been able to achieve these operating efficiencies without compromising economic returns via decrease of equity offerings. As such, our net ROE snapshot falls out around 14% and what is interesting is that unlike the prior quarters, the agency and non-agency ROE projections are now very close to each other, while in the past the agency ROE (inaudible) the non-agency numbers.
It is important however to recognize that some of this is just a function of changing market conditions, but a large component of it is our decision to wrong the considerable lower risk position on the agency side of the business; at least temporarily.
The bottomline is that we feel our portfolio is extremely well positioned for the current environment and that we can produce attractive returns across a wide range of economic conditions at interest rate scenarios. As such, even the historically low level of interest rates, this is not the right time to make large interest bearing debts.
This management team takes pride in executing against an objective of producing industry leading risk adjusted returns which requires putting a significant amount focus on the mismanagement component of the business.
So with that, let me open up the call to questions.
(Operator Instructions) The first question comes from Douglas Harter of Credit Suisse.
Douglas Harter - Credit Suisse
I was just wondering Gary, if you could talk about what might be some of the changes in the market which would lead you to sort of take a little bit more risk sort of from the position you are sitting in today?
You know it depends on a couple of different factors. I would say the number one factor is getting -- one big factor would be getting a little more clarity from the Fed on kind of where they stand, a little more clarity on Europe and just the absolute rate level; all of those are kind of factoring into our views right now.
The other thing is that it also it’s dependence on pricing as well and so while this is an environment from like a rate level perspective that we would be comfortable with much higher, with materially higher leverage maybe, but prices have done pretty well both on the agency and non-agency side, so this is not a time in a sense where pricing is to back up the trunk. So to speak again, we are very comfortable with the risk adjusted returns, but we view this as a period where being -- again temporarily being a little more conservative is the right approach.
(Operator Instructions) The next question comes from Joel Houck of Wells Fargo.
Joel Houck - Wells Fargo
Just a point of clarification, in the Q, the weighted average coupon on the non-agency book is, actually I am looking at the March 31st, but the weighted average coupon seems to be relatively low and I know these are obviously purchased at discount. In the footnote it says these are mostly floating rates, but can you maybe talk about it or add a little more color on why is the weighted average coupon average is low 1%?
Yeah sure Joel, this is Jeff. I think that between most of our Alt-A in the royalty prime model, so of course hybrids which will have a coupon in somewhere with a sort of a two handle. We also have some bonds that have floating rate coupons even though they are backed by higher coupon collaterals.
So for example as you have a subprime bond which is say a LIBOR plus 20 type coupon that's obviously going to be extremely low, but a lot of those bonds that we have are effectively just backed by the loans; there is no credit enhancement.
So because of the structure of those bonds, we are getting the coupon of the collateral paid in the form of principle on a lot of those assets. So that's why potentially the coupon was low, but in reality we are getting the benefit of the coupons and the underlying collateral.
Joel Houck - Wells Fargo
Okay; that's just more of an accounting issue more than economic issue?
Joel Houck - Wells Fargo
And then just in terms of perspective comments on book value, and I think Gary indicated that its similar to AGNC that has obviously moved up nicely in here beginning of the third quarter; I mean is there any differences in terms of strategy with MTGE in terms of given smaller and you can be more flexible and nimble, any important distinctions you would make to investors relative to running a larger book on MTGE?
Yeah, I think, look people should -- when we think about MTGE, we think of it as being a hybrid REIT and it has some exposure to the non-agency sector where you don’t have the same kind of pure interest rate risk and negative convexity. So absolutely overtime MTGE is generally speaking in a position to take more convexity exposure and may be a little more interest rate risk in its mortgage portfolio.
So I think you can expect that overtime; I think that we are just going to be very tactical about how we do that and we are just not going to -- it’s not something we’re necessarily going to be doing all the time. There really are times when again, we are very constructive on the market; I don’t want people to take away from a lower risk position that we are really nervous and we think something is going to fall apart because we actually don’t; we just think that we are sort of, there is a number of different factors going on and it’s very possible that there will be a entry point into certain assets.
(Operator Instructions) Showing no further questions, the conference is now concluded. An archive of this presentation will be available on MTGE’s website and a telephone recording of this call can be accessed through August 21st, by dialing 877-344-7529 using the conference ID 10015856. Thank you for joining today’s call. You may now disconnect.