Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

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

William H. Gibbs - Co-Chief Investment Officer and Executive Vice President

Analysts

Arren Cyganovich - Evercore Partners Inc., Research Division

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

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

Steven C. Delaney - JMP Securities LLC, Research Division

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

Daniel Furtado - Jefferies & Company, Inc., Research Division

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

Benjamin Ram - OppenheimerFunds, Inc.

Hatteras Financial Corp (HTS) Q3 2012 Earnings Call October 24, 2012 10:00 AM ET

Operator

Good morning, everyone, and welcome to the Hatteras Q3 Earnings Conference Call. [Operator Instructions] Please also note that today's event is being recorded. At this time, I would like to turn the conference call over to your moderator, Mr. Mark Collinson, CCG. Sir, please go ahead.

Mark S. Collinson

Thanks so much. And good morning, and welcome to the Hatteras Third 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, Ken Steele. Also available to answer your questions are the company's Co-Chief Investment Officers, Bill Gibbs and Fred Boos.

Just quickly before I hand over to them, I need to remind you that any forward-looking statements made during today's call are subject to risks and uncertainties, which are discussed at length in our annual and quarterly SEC filings. Actual events and results can differ materially from these forward-looking statements. The contents of this conference call also contains time-sensitive information that's accurate only as of today, October 24, 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 all for me. Here's CEO, Michael Hough.

Michael R. Hough

Good morning. Thanks for joining our call today and for your interest in Hatteras. As always, the entire management team is on the line to answer any questions you have following some brief prepared remarks.

Before we discuss the mundane of our earnings, I'd like to briefly express our thoughts on the loss of Mike Farrell. We want to first convey our sympathies and best wishes to Mike's family and to his close friends and coworkers. We know he will be greatly missed. All of us at Hatteras and the mortgage industry as a whole will miss him as well, and we'll miss his leadership and principled approach to business that we all enjoyed the benefits from. Michael is our industry's best spokesman, our most progressive thinker and the one the market looked to in times of stress. We will recognize at every opportunity the path he paved for us. At Hatteras, we want to wish the Annaly team good luck and for a smooth transition through this difficult time.

So as far as our report goes, Hatteras had a very good third quarter, especially with all things considered. While we reduced our dividend by $0.10, to $0.80 per share, it still equates to a very attractive yield and is more indicative of the lower interest rate market we have today. In today's share price, an $0.80 quarterly dividend equates to about a 12% annualized yield. Even though margins have compressed somewhat, the carry power and short-duration agency mortgage-backed securities continues to allow for risk-adjusted returns such as these.

However, there is no reason for us to reach for yield by changing our risk management approach, especially in a market where most yield and spread products have declined to new recent lows. On the contrary, market risk will need to be managed more diligently.

On the equity side, our book value on September 30 was at an all-time high of $29.60. The increase quarter-over-quarter was not as much a result of positive duration as much as it was a combination of a significant basis change in MBS and the excellent timing of our preferred stock offering in August. In August, we raised $278 million in a preferred offering that serves Hatteras well on multiple fronts. As an unrated company post credit crisis, being able to accretively issue preferred equity is a luxury, especially one that meaningfully exceeds the expectations of everyone involved.

For one, we matched the lowest-ever mortgage REIT preferred coupon, further proving that Hatteras has one of the lowest costs of capital. Second, $278 million puts our issue at a size we think benefits investors with good liquidity, which could also improve future access to this market. And three, we were able to allocate the proceeds into attractive paper ahead of the rally and basis type. This, by itself, allowed us to quickly take advantage of the backup in the market during August. It helped us add some more stability in managing to our long-term duration targets. And it enabled us to hedge a little for the possibility of QE3, which we were uncertain about at the time. So all in all, we were very pleased with the success of the deal and benefits the company enjoys from it.

So what I really want to use this time for was to make a point about how we are looking at new risks being introduced into the market. There are looming headline risks out there, including the election, the fiscal cliff, potential leadership changes at the Fed and the Treasury, among others. There are a lot of wildcards that we have to factor into our operation, including, most recently, QE3 and what it means now that we are competing daily with an open-ended buyer of maybe half of the new agency MBS production.

Along with that, the fact that the Federal Reserve is unlimited in its purchasing power with no economic incentive and has stated that the program has no defined timeline, makes us have to think about risk management a little more broadly.

Our first takeaway on this new QE program is if the Fed is focused on the purchase of fixed-rate securities and not hybrid ARMs, which could ultimately work to our advantage, not sure. But there are going to be issues we'll have to deal with. And the unintended consequences on the back end are going to be tough to predict.

The Fed is creating new policy tools with their own balance sheet that can influence our business meaningfully. We'll have to address this from both a short-term and a long-term perspective under the assumption that we don't really know when open-ended will actually end. And we don't have any real sense what the ramifications will be from the open-ended printing of new dollars on the country's balance sheet and how inflationary it may ultimately be.

Added uncertainties mean we have to consider the possibility of positioning the company even more conservatively than before. Our number one objective beyond our stated balance sheet management is to be properly prepared should anything unexpected surprise the market. We can't afford to blindly max out returns that may be available today at the expense of being unprepared later. We'll have to constantly evaluate all of our options and be willing to make the best risk management decisions, no matter how tough they may be before the opportunity to do so passes. Just because the Fed may want us to take more risk doesn't mean we think we should.

All of this being said, we do have the portfolio mix we want for this part of the cycle and we like where we're sitting with the flexibility we have. We are pleased that we can provide good risk-adjusted and noncorrelated returns to our shareholders and expect the long-term approach we take will pay off in spades.

So with that, I'll turn it over to Ken to detail the quarter.

Kenneth A. Steele

Thanks, Michael. Good morning, everyone. As most of the events during the quarter related to macro themes that are a little less on the financial side, I'm just going to highlight a few of the numbers today to give Ben a little more time to discuss the portfolio and for questions.

Our operating results for the third quarter were primarily driven by the components of compressing interest rate cycle. That is, the curve was flattening, putting pressure on new purchases along with repayments being a bit faster than normal. Our top line yield compression was also accompanied by further tightening their repo rates and repo rates remain somewhat disconnected from LIBOR.

Our net income for the quarter was $82 million, or $0.83 per weighted average share, as compared to $91 million, or $0.89 per weighted average share, for the second quarter of the year. Our net interest income was $79.6 million in the third quarter of 2012 compared to $83 million for the -- in the previous quarter. We had significantly more earning assets, so this drop is reflective of the lower yield environment.

Our average MBS for the quarter was $24.4 billion, up from $21.1 billion in the previous quarter. We also sold $740 million of securities during the quarter for a gain of $10.5 million. Our MBS had an approximate weighted average coupon of 3% during the third quarter and had a yield of 2.16%. This yield was a decrease of 27 basis points from the second quarter. This is mostly driven by a 30% increase in our amortization expense.

Amortization expense rose from the second quarter of 2012, going from $35.9 million to $47.2 million in the third quarter of the year. While the portfolio was larger, we also had a slightly higher cost basis than some of our higher cost assets began to see. Our average 1 month CPR increased, going from 19.7% in the second quarter to 20.5% in the third quarter.

Our cost of funds is unchanged, at 94 basis points for the quarter. While we are able to take advantage of lower swap rates on our new contracts, repo rates moved up and offset that gain. We should be able to continue to lower our average swap rates as we replace older, expensive swaps with new, much lower rates in the coming months. All together, this led to an interest rate spread of 120 basis points for the quarter, a decrease of 27 basis points from the previous quarter. Our operating expenses was $6 million, which was an annualized rate of 84 basis points on average equity.

In summary, despite a few continued headwinds, our portfolio performed well and we ended the quarter with a balance sheet and liquidities strong and declared our first preferred dividend.

With that, I'll now turn the call over to Ben for details regarding the portfolio and our investments.

Benjamin M. Hough

Thanks, Ken. I'd like to start by going over some of our portfolio activity, then follow up with some general market points that could drive returns going forward.

First, on the portfolio. As Michael mentioned, the timing of the preferred equity raise is very good. Due to the backup in yields at the time, we quickly purchased about $2.3 billion in securities with the proceeds, with about 85% of that going into lower coupon, 15-year fixed paper, the rest into hybrid ARMs and with all of it settling on or before mid-September.

The percentage of 15-year was a little higher than the past but seemed like a prudent move at the time, given the duration of our existing portfolio and the impact QE3 might have on it. However, we still prefer the lower durations of hybrid ARMs and will continue focus there. So while book value was up $2.15 per share for the quarter, we estimate about $0.40 to $0.50 of that can be attributed to just the assets and liabilities acquired with the proceeds from the preferred deal. The remaining book value gain came from the significant tightening of MBS to swaps in our existing portfolio. Overall, our swaps decreased in value by only about $0.20 per share while the rally in our assets added about $2.40 per share.

It's important to note that being on the shorter end of the curve, the impact on hybrid ARMs from the flattening was not as dramatic as on fixed. Generic prices on low coupon ARMs were up about 1 to 1.25 points quarter-over-quarter, while low coupon fixed-rate securities were up by 2-plus points.

Now we also realized some gains again this quarter by selling about $740 million securities, which consistent with prior periods, we've done when rates have declined and we have identified pools we expect to underperform. And just about everything we own is marked at a gain and will result in additional income at sold.

Prepayments for the quarter came in at a 20.5% CPR. On a monthly basis, they were very steady, between 20% and 21%. We're looking into this into Q4, our October prepayments came a bit lower, at 18% CPR. Our CPRs have been very consistent now for the last 12 months, right in the middle of the 18% to 22% range we've provided. That consistency helps us manage cash flow and hedge it effectively.

As we move forward, there's a little bit more uncertainty. With the announcement of QE3 in September, there was a spike of refi activity, which will probably translate into slightly higher CPRs in November and December. However, we expect some relief after that, as refi activity has subsided, which was demonstrated by the 13% decline in the mortgage refi index today.

After that, it's more uncertain, but we are not currently expecting a large, prolonged spike in prepays, given some of the offset, such as higher GPs [ph] and capacity constraints. That said, we could see some originators add capacity to take advantage of the opportunity, so the longer-term prepayment picture will depend not only on interest rates but also on other factors that may impact the primary and secondary spread.

Now on the liability side, there are 2 things to note. We continue to add duration to the swaps book by adding swaps longer than the stated duration of our assets. We added $800 million in new swaps during the quarter, all in the 70 to 90 basis point range, with 4 to 4.5 year maturities and most with forward start dates. Using forward starts, we get duration protection today, but they won't affect the income statement until their start dates. There's a table in the release that should provide more detail there.

One brief note on swaps. We're preparing for the inevitable move towards Dodd-Frank clearing mandates. While eventually there will likely be some impact on liquidity due to increased margin requirements, it will happen gradually over the next few years and we've been preparing for this for a while. At this point, we don't expect that there will be any significant impact on our overall operations.

Repo rates have been steady, in the 38 to 40 basis point range, and have not declined with LIBOR, which has added a little spread compression from the liability side. Repo rates will likely remain elevated through year end, but we may see some of that pressure ease in the first quarter.

And finally, just a few general market points to make. The Fed is now an even bigger gorilla in the room, with no economic restraints and with completely different investment objectives from the rest of the market. There are 3 likely immediate effects. First, spread compression may continue over the short run as we gradually reinvest paydowns into low yields. Our average yield was 2.16% last quarter and new 7/1s, for example, currently yield around 170. As some compression is likely, but, again, ARMs have already experienced more compression over the last 3 years than the long end of the curve. New capital today can be invested at around 130 basis points depending on asset mix.

Secondly, repo rates could benefit in the long run as overall liquidity increases and collateral is removed from the market by the Fed. We think our collateral will be more in demand from the cash market going forward and that the upward pressure on repo rates compared to LIBOR should ease next year. We've seen estimates from repo analysts meaningfully lower than today's rates.

And the third and last point is on agency MBS supply. While auto production is down from historical levels and the Fed is absorbing much of the new production, market still provides what we need and we like the relative value of 7/1s in particular. Our cash flow needs are in the $500 million per month range, give or take, and agency ARM production has recently been averaging over $3 billion per month on top of what's available in the secondary market.

But there's still plenty to satisfy our demand. We like the fact that we own $22 billion of ARMs that are in high demand and the fact that our portfolio couldn't be replicated today. So with that, I'll turn it back over to Michael.

Michael R. Hough

Okay. One last thing before we open up for questions. Hatteras Financial was formed 5 years ago next week. Over those 5 years, we have generated 143% total return to our investors, which translates to an annual return of over 20%. We are extremely appreciative for the support of all of our investors and interested parties, from the folks who supported us in that first private offering to the ones that are buying our stock for the first time this morning.

Our long-term success is truly a result of the support of our investors. The appreciation for our approach to this business validates our strategy and is what has helped us maintain a strong ownership base, a low cost of capital and to stay true to our principles. We are very appreciative of that. So now we can open up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Arren Cyganovich from Evercore.

Arren Cyganovich - Evercore Partners Inc., Research Division

Michael, your comments about the risk in the market today, I was wondering if you could maybe elaborate what actions you might be able to take with the portfolio to maybe lock in some of the gains that you have. You generated a very strong amount of gains this quarter. And what impact would you have, I guess, both to the spread and to your potential book value by those potential actions to derisk the portfolio?

Michael R. Hough

Yes. The primary point that we were making there was that because there are uncertainties that maybe we haven't had before, that we need to be prepared to take any and all actions that would help the company be more defensive. And so long term, there's all kinds of ways that we can add defense through, through the liability side, through the leverage side, to the capital structure, et cetera. As far as the gains we have in the portfolio today, yes, that was -- they are significant gains that we would like to protect as many of those gains as we can. But we're going to have to evaluate all of the tools that we have and make those decisions going forward. So it's very difficult for us to say what we're going to do other than we are going to evaluate all of our options.

Arren Cyganovich - Evercore Partners Inc., Research Division

So from our perspective, you basically kind of sit pat at the moment on your current strategy and leverage expectations?

Michael R. Hough

Well, I think just think about what's coming. We have year end coming, we have the election coming, we have the fiscal cliff looming. There are a lot of things, especially heading into year end, we need to be wary of. And I think liquidity is our #1 ally as we run this business. And we will, if nothing else, make sure we have a strong liquidity position heading into year end.

Arren Cyganovich - Evercore Partners Inc., Research Division

And then just lastly, the $900 million of swaps that you have, I guess, rolling off over the next 12 months, are there any of that included in the fourth quarter?

Michael R. Hough

I included in the -- yes, $200 million comes due in the fourth quarter, about 1.75% rate or so. So $200 million of it this quarter.

Operator

Our next question comes from George Bose from KBW.

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

This is Bose. A couple of things. First, just on prepayments. I mean, given what you guys are seeing in the market, is the 18% to 22% CPR range something you guys are still comfortable with?

Kenneth A. Steele

I think Ben touched on that a little bit on his opening remarks. We would expect to see probably for the next couple of months somewhat elevated over that level. If you look at where the refi index peaked about 3 or 4 weeks ago, we should expect to see that start to flow through probably in November and December for us. If you look at it, what's happened since that time, we've seen some backup in rates here, refi index has come off a little bit. We would expect to see maybe some relief in the beginning of next quarter.

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

Okay, great. And then just in terms of capital allocation, your shares are around 90% of book value. Just given high MBS prices, is buyback a potential use of capital?

Michael R. Hough

We've addressed this issue the other time that we were trading it, discount the book, which didn't last very long. A stock buyback program has to be one of our tools, and it's one of the very few ways that we can accretively grow book value, buying stock back at a discount. But we have to be comfortable that we could -- if we implemented a buyback program, it would have to have a meaningful impact. And so looking forward, the greater the discount to the underlying value of the company and the longer it remains that way, the more likely we're going to be to buy back the stock. Now not that having a program in place is not -- may make sense, but to utilize that, we have to be able to have a meaningful impact on the company.

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

Okay. That definitely makes sense.

Operator

Our next question comes from Mike Widner from Stifel, Nicolaus.

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

You talked a little bit about the mortgage basis tightening or MBS to swap spreads tightening, and that drove a lot of the book value gain. I'm wondering if you could talk a little bit about what you've seen since the quarter end. I mean, certainly MBS prices generically have drifted a little bit back down, at the same time, swap rates have drifted up. But just wondering if you could talk about whether you think we might have had a little bit of a spike there just because we're a couple of weeks after QE3 or basically just how things have progressed since then and what the implications are.

Kenneth A. Steele

Yes, Mike. If you take a look at what's happened since the end of the quarter, you've definitely seen Treasury give back some ground. Mortgages, in particular, as far as the ARM portfolio is concerned, these spreads have remained relatively constant. So with the backup in Treasury rates, we've seen bond prices drop off a little bit, too. I would say probably, if you looked at overall portfolio in terms of ARM prices, you're probably looking at maybe somewhere between 1/4 to 3/8 of a point pullback since the end of the quarter. And if you looked at 15-year fixed, probably closer to 5/8.

William H. Gibbs

And I'll add just to that. The origination rates are back up, too. We've seen 30-year rate back up from, say, 3 3/8% to 3 3/4%, 3.60% kind of level, 15 years back to high 2s. And a lot of stability in the 5/1 and 7/1 at 2.5%. So the market is, I think, reacting to that as well. As Ben pointed out, the primary, secondary spread is still pretty wide, 130 basis points. So those factors all weigh in, I think, as well. To put a bit of caution, say, in the markets move higher despite the Fed looming out there in terms of buying paper.

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

So I mean, just pushing a little further on that, I mean, as we sit around and look at it, I mean, broadly speaking, it's hard for me to mark 5/1s. But looking at 30-year fixed and 15-year fixed and looking at the moves in related swaps, generically speaking, it would imply that the pop in book values in Q3 probably subsided a little bit as that tightened basis, I wouldn't say widened that dramatically, but drifted out a little bit more. But on top of that, just kind of adding to one of Arren's questions, I think, is there anything you can do or anything you would do, given that book value stability is kind of one of the goals to sort of hedge the potential for spread widening back out? Or anything you can do, not necessarily to lock in book, but at least to protect against the possibility that -- it was a hell of a gain at the end of the day, I mean. And so anything you can do to sort of preserve that if the spreads are going to widen back out, it would certainly be helpful. So I was just wondering if you have any other thoughts on that.

Michael R. Hough

Yes. I think what we're going to -- the way we're going to look at this is that we had the basis tightened, the market adjusted to the Fed announcement. We were the beneficiaries of that at the end. There are -- I think the primary risk that we are able to manage against, we want to lock in against is interest rate movements. And we will adjust our duration that we're carrying, the net duration that we're carrying. And we can do that through added swaps. We can do that through lower leverage or both. I think those are the primary tools that we will use at this point in time. And again, keep in mind, liquidity is our friend in here. And that's going to be an important part of this. So from the basis, I don't -- I think the market will and has already shown that the basis is going to adjust based on forward expectations and we're going to -- but we're going to focus on the interest rate side of it.

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

Okay. And then just one final one, as we look at your leverage, it came down a little bit. You had some capital raising. But certainly, I would expect that part of that was just the increase in book value, the increase in the equity value, drove the apparent lower leverage. But as you guys think about leverage going forward and what to do here, should our expectations be kind of portfolio size constant or kind of the leverage constant or in the same range or up, down? I mean, how do you guys think about it and how should we think about it when modeling?

Michael R. Hough

Well, that's a good question. We've been pretty consistent in the -- given our leverage, the driver of our leverage being that the liquidity is driven by liquidity and the liquidity position we want to have relative to the portfolio we have. And that continues to be -- we'd be comfortable with a 7.5x to 8x leverage number. You're right that, that leverage came down last quarter more from the movement in equity and the mid-quarter offering. But going forward, I think liquidity is again, I'm going to say it again, is that it's important to us. And we could operate at a slightly lower leverage through this quarter going forward. But I think 7.5x to 8x will continue to be a comfortable number for us.

Operator

Our next question comes from Steven Delaney from JMP Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

Michael, I guess I'd first say, as one of the old-timers, I really appreciate what you had to say about Mike Farrell. Very well said. The question, I wanted to ask about the bond prices since the end of the quarter. And Bill gave us some pretty good indications. Those moves were in line with what we expected, about 0.25 point down on the hybrids and about 0.5 the 2.5% 15s. Could you comment in the third quarter on your hybrids. Because as Mike Widner said, getting accurate ARM pricing is a little difficult. Our sources showed us that the sort of early 2012, late 2011 vintage ARMs, maybe the 2s to 2.5s were probably up about 1 point in the third quarter. Does that ring true just generally to what you guys saw?

Michael R. Hough

In the 5/1 sector, Steve?

Steven C. Delaney - JMP Securities LLC, Research Division

Yes. Excuse me, yes, in 5/1s.

Michael R. Hough

Yes. I think about 1 point is I would peg it as well.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay. Very good. And as you said, down 1/4% to 3/8% possibly since?

Michael R. Hough

Correct.

Steven C. Delaney - JMP Securities LLC, Research Division

Yes. And just real quickly, one follow-up on repo. You gave us your average for the quarter of 41, so up about 5 bps. The average rate as of September 30, do you have that handy?

Michael R. Hough

The average rate on September 30?

Steven C. Delaney - JMP Securities LLC, Research Division

Yes.

Michael R. Hough

I think it was right around 41 or 42.

Benjamin M. Hough

I think 42 would be a good guess.

Steven C. Delaney - JMP Securities LLC, Research Division

Yes. In that same ballpark. Okay. And Ben's 38 to 42, not to belabor it, but repo is, I think, becoming more of a -- something we have to all keep an eye on. Was it 38, 42 for basically a 30-day roll but not across year end? Is that -- because I heard last week some people paying 50 to go into January.

Michael R. Hough

We've seen people as high as 50 for getting into January. But it seems like the last couple of days, we've put some paper out over year end. And I think the low end was like 44 basis points and the high end was like 48.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay. Very good. I appreciate that update on that cross year-end market.

Operator

Our next question comes from Jason Weaver from Sterne Agee.

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

To start, just given your comments on hybrid production as a proportion of overall issuance looking forward, that sort of leads the question, seeing the growth of 15-year fixed bucket, is that more of a result of the general supply constraint in hybrid product or more of a relative value move, given the movement in MBS yields now?

Michael R. Hough

The way we were looking at it from that perspective, it wasn't that we were looking for an alternative to hybrids because of production. It's how it fit in our portfolio in regards to our overall asset liability. The duration on our hybrids with the recent drop in rates had shortened, and it worked -- it definitely made sense for us add some duration on the asset side, and the 15 years made a lot of sense.

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

Okay. And actually just to that comment you just made just then, it looks like those 15s are a mix of 2.5s and 3s. I was curious if you could ballpark what the hedge duration is you're matching with that paper?

Michael R. Hough

It's pretty much we've been using on the swap side to offset that, the 4- to 5-year swaps.

Operator

Our next question comes from Daniel Furtado from Jefferies.

Daniel Furtado - Jefferies & Company, Inc., Research Division

I just had a conceptual question for everybody. Assuming the next couple of months, CPRs peak up and then they start to settle back down, if rates are stable to slightly increased from that point. Help me understand, isn't the best way or one of the better ways to hedge the portfolio moving forward, again after the spike in CPRs subsides, by using some combination of mortgage servicing assets or IO type of paper?

Michael R. Hough

Well, keep in mind, short duration of our portfolio, one, the type of securities see we have. Yes, I would agree that you can get some nice negative duration with our portfolio with MSRs or IOs. At this point in time, I don't feel like it's the right cash flow match for the assets that we have. But we are doing a lot of work, specifically on the MSRs. And we will continue to look at that as a possible hedge for our portfolio. But right now, I think swaps and maybe interest rate caps are the best cash flow hedges that we have for the type of assets that we have.

Daniel Furtado - Jefferies & Company, Inc., Research Division

And historically, have you ever used MSRs or IO type hedges on the book?

Michael R. Hough

We have not at Hatteras or at our private company, where we have had very short-duration ARM portfolios.

Operator

Our next question comes from Joel Houck from Wells Fargo.

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

The comments, I guess, on new 7/1 production yielding 170. I'm assuming your cost of funds, obviously, is more stable. So you've kind of got an interest rate spread on new production of 75 basis points. Is that -- am I thinking about that correctly?

Michael R. Hough

New production relative to our existing?

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

Yes. So in other words, if you get repayments in, that's being deployed on the margin at a spread of about 75 basis points.

Michael R. Hough

Yes. I mean, if you take our average yields and you -- that's why I gave you that 2.16% number and putting on 170, yes, there's spread compression on that peak. We're also going to get a little help from the cost of funds side on swaps going forward, and maybe on repo, as we round the turn into next year. But yes, if you want to connect the dots to that number, that's probably right on that incremental piece of paper, yes.

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

Okay. So probably not as low as 75, given you'd probably get some funding cost benefits into next year?

Michael R. Hough

Exactly.

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

Okay. And then I may have misread, but I thought I heard a comment about new capital being deployed at 130 basis points?

Michael R. Hough

Right.

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

What were you referring to?

Michael R. Hough

So it depends on the asset mix. But again, if we're doing -- if we're getting just 7/1s, for example, we do, once we get a 170 yield there, we mix it depending on the swap term. We do it 50%. For example, if we swap 50% of that out, you're going to get a cost of funds in the 40 to 50 basis point range. So it depends on the asset mix and how you swap it. But that's just a general ballpark. The 130 was not meant as a data point, except just as a general ballpark of what we can do depending on the asset mix and how we hedge it.

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

Okay. So that was kind of more of a portfolio -- the 130 is more of a portfolio comment, the 170 is the specific product comment?

Michael R. Hough

Exactly. I mean, that's what the market has given us.

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

Okay. I just want to make sure it's clear. And then I guess, finally, you guys have done a great job over the last 5 years in terms of hedging. And your comments about, I guess, heightened risk is a good one. I'm wondering, what is the -- if you look at prepayment speeds of hybrids, I mean, historically, when do you get concerned with the long end of the market coming down that 5/1, 7/1 borrowers would jump over to a 30-year product? I mean, you see this 30-year now hovering slightly below 3.50, your weighted average coupon is 3%. So presumably, they obviously don't make that jump today. But is there a point where prepayment speeds could actually rise for hybrid products? I'm just trying to get a sense for where that sensitivity is.

Michael R. Hough

Yes. Just before I hand it off here. I mean, that's part of it. That's one of the drivers of refinancings, of course. And that's something that we've seen. We see -- we've said this just probably just about every call that we've had, that an ARM borrower has the option of going from an ARM to an ARM or an ARM to a fixed. And that's just part of the prepayment and rate management that we do here.

William H. Gibbs

And the slope of the mortgage curve is key element in that incentive for the ARM borrower. We're still above 100 basis points between a 30-year and a 5/1. And the 7/1s are really around top of each other. And that's still a strong incentive for a borrower to go down into an ARM. We don't -- while we see the pressure, obviously, in the 30-year fixed market with the Fed being the buyer, we don't see that curve slamming down too quickly. So as long as that slope stays pretty positive, we're comfortable that ARM production will continue at its current rate. And that while we'll lose some borrowers certainly to fixed, but the incentive is still strong for an ARM.

Operator

Our final question comes from Benjamin Ram from Oppenheimer.

Benjamin Ram - OppenheimerFunds, Inc.

Just a follow-up on Joel there, and Bose and Mike kind of touched on this earlier. And correct me if I'm not thinking about this properly, but you have your current investment rates at extremely low levels. And I'm not sure what the ROEs you can generate with those kinds of yields on new production are. But I'm assuming they're substantially lower than the ROEs you're putting up now. And given the fact that your total book has increased in value because of artificially -- kind of because there's a buyer in the market right now that may not be there for much longer. But would it make sense to shut the plant down, so to speak, I mean, just to shrink the company? And given the fact that it's just not -- it's not as profitable anymore to buy these things and the stuff that we have has gone up in value for some strange reason or because the Feds is buying these bonds. And let's sell all that stuff. Let's buy back stock. Let's do a big dividend or something like that, that would shrink the company down until things get more rational.

Michael R. Hough

Well, first of all, we're still operating with defensive assets. We're able to hedge them pretty aggressively and still generate what we think are very attractive risk-adjusted returns, especially relative to other investment vehicles or yield vehicles. So for one, I don't think that -- and it's not like we're -- there's not interest spreads here to make. And if we wanted more return, we could get more return. The market will give it to us. We can take as much risk as we want to generate as much return as we want, pretty much. We're very convicted in running this business the way we run it. And we take a long-term perspective here, and it's not -- the fact that we have a tick down in rates does not mean that we are not going to be able to provide very attractive risk-adjusted returns throughout an interest rate cycle. But we're going to do it in a very risk-conscious way. And those points, we always try to make. So we could go out the yield curve. We could go out the leverage curve. We could -- we can take more risk and get more return. But we're just not just going to do it. So we think we have the right portfolio, the right mix of assets and liabilities to get us through the trough in the rate cycle and the peak in the rate cycle. And that's what we're trying to do and that's why we take such a long-term perspective. But if the economics are ever such that it makes more sense to buy back stock than reinvest capital or the whole liquidity for better opportunities, then it's definitely something we'll consider.

Benjamin Ram - OppenheimerFunds, Inc.

So on that 70 basis points that you were just mentioning to Joel of the new spread, what does that translate to profitability? And what's the ROE on that, on the new stuff that you're putting on?

Michael R. Hough

Well, I mean, it's 70 basis points and that's very incremental. That's not a huge part of our portfolio. And just like what we said, our cost of funds is going to continue to come down. We've had an uptick on the cost of funds on the repo side. We have swaps. We have swaps rolling off so that number is going to come down and recapture some of that, too. But again, we said -- and we want to put ourselves in a good position to be able to take advantage of the market when it's attractive. I think we've done that. We've proven that, that's our MO in the past when we raised capital. And that's going to be our MO going forward. And liquidity is king. So anyway, I definitely understand your question and -- but I think it's important to note that we're still very confident in the long-term profitability of this business.

Operator

And with that, we will end today's question-and-answer session. I'd like to turn the conference call back over to management for closing remarks.

Michael R. Hough

Once again, thanks, everyone, for being on the call today. And we sure do appreciate your interest and we look forward to the next quarter. Have a great day.

Operator

Ladies and gentlemen, that concludes today's conference call. We do thank you for attending today's presentation. You may now disconnect your telephone lines.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Hatteras Financial Corp Management Discusses Q3 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts