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Capstead Mortgage (NYSE:CMO)

Q3 2012 Earnings Call

October 25, 2012 9:00 am ET

Executives

Kelly L. Sargent - Manager of Investor Relations

Andrew F. Jacobs - Chief Executive Officer, President, Director and Member of Executive Committee

Phillip A. Reinsch - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Secretary

Robert R. Spears - Executive Vice President and Director of Residential Mortgage Investments

Analysts

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

Steven C. Delaney - JMP Securities LLC, Research Division

Jackie Earle

Operator

Good morning, and welcome to the Capstead Mortgage Third Quarter 2012 Earnings Conference Call and Webcast. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Kelly Sargent, Vice President of Investor Relations. Please go ahead.

Kelly L. Sargent

Good morning. Thank you for attending Capstead's Third Quarter 2012 Earnings Conference Call. The third quarter 2012 earnings press release was issued yesterday, October 24. The press release is posted on our website at www.capstead.com. The link to this webcast is in the Investor Relations section of our website and an archive of the webcast will be available for 60 days. The telephonic replay of this call will be available during [ph] November 26. Details for the replay are included in yesterday's release. Starting off today's call is Andy Jacobs, our President and CEO. But before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC which are available on our website. The information contained in this call is current only as of today's date, October 25, 2012. The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that, I will turn this call over Andy.

Andrew F. Jacobs

Thank you, Kelly. Good morning, and my welcome as well to the third quarter 2012 earnings call. As usual, I'm joined by Robert Spears, our Portfolio Manager; and Phil Reinsch, our CFO, both of whom will be available for questions after some of my brief opening remarks.

Operating results for the quarter. Net income totaled $40 million or $0.35 per diluted common share. Net interest margins for the quarter decreased to $43.6 million as a result of a 20 basis point decline in financing spreads on mortgage investment portfolio, 230 basis point. And I just want to point out here, the financing spread as presented, this is a non-GAAP measure based solely on the portfolio. This is different than the presentation in the past, which has been more focused on what the GAAP requirement was, which -- and previously included other interest-bearing assets and liabilities in the yield calculations which kind of threw that number off. So this is more of a pure number associated with our core portfolio. And I think you'll find a new schedule. It's on Page 10 of our press release. And then we also have on Page 10, the reconciliation between GAAP and non-GAAP. So I think I've covered my SEC requirements there.

Anyway, portfolio yields averaged 1.86%, representing an 18 basis point decline from the second quarter. Yields were negatively impacted primarily by higher investment premium amortization, resulting from higher level of mortgage prepayments, which averaged 18.7% CPR in the third quarter compared to 15.9% than the previous quarter. The yields were influenced by prices paid on more recent purchases over the recent -- with the run-up in prices for mortgages in the recent past. And the yields also reflect declines in the weighted average coupons on the company's portfolio, of our ARM loans which we're resetting to the current indexes which we continue to expect will have some impact going forward that will be mitigated.

Interest rates on our repo borrowings, including the effects of our swap agreements, averaged 56 basis points in the third quarter, which were 2 basis points higher than they were in the second quarter, which is reflecting just generally higher, slightly higher repo borrowing rates. And our operating cost and the way we define it as a percent of our long term investment capital, which is our long-term capital, declined 88 basis points during the quarter from 106 basis points during the previous quarter. As a result, there's continued growth in the long-term investment capital, as well as lower compensation-related accruals.

Regarding the portfolio acquisitions during the third quarter averaged $1.2 billion, which more than offset the runoff during the period, which was $777 million. And overall, our investment portfolio increased to $14.3 billion. I want to point out that 58% of this portfolio is still invested in the shorter duration ARM securities. Those are basically securities that will reset in rate within the next 18 months. As I mentioned earlier, the portfolio runoff increased 2.8% CPR to 18.7%, which reflects the lower prevailing mortgage interest rates available, as well as some seasonal patterns. Mortgage rates will continue declining with the consequence of the QE3, and which is the Fed working to treat -- to get mortgage interest rates lower. The -- I think there are certain characteristics in our portfolio that lessen, we believe, the risk of experiencing sharply higher interest rates, one of the reasons because of the current reset portion is such a significant part. So -- and then I think that's one of the primary fundamental differences between our portfolio and most of our peers. As of the end of the quarter, our overall portfolio was backed by mortgage loans requiring homeowners to make mortgage payments on a relatively low 3.37% coupon. That's generally below what the longer end, the 30-year fixed rate-type product is in this world. And of this, of our portfolio, 56% was originated prior to 2009. So with the more seasoned portfolio, you have it in there the issues associated with credit issues, loan-to-value ratios because these people were in their houses more and during the crisis versus after and with better underwriting after the crisis occurred. So we think that the homeowners are somewhat locked out of the opportunities to prepay as fluently as they had in the past, over the last decade. So we think that -- I think we -- mortgage prepayments, they're going to be higher to some extent because of the implications of what the Fed is trying to do, but we think that they'll be manageable from -- for our purposes with our portfolio, we think we have good attributes that will cause that to be reality.

Borrowing costs have remained largely in check. We have seen some increases. And as we move in the year, towards year-end, borrowing costs on repo are still elevated from where they were in previous quarters this year. But all in all, it's still a very positive market there. There's availability of repo, and we really don't see any concerns, but the issue is just whether you're having to pay a little bit more today with just banking system. It costs you a basis point or 2. That adds up. But all in all, the key is that there's availability, and we don't see any concerns or cracks with that part of the market.

As I mentioned earlier, our long-term investment capital, we actually -- it grew during the quarter to -- up $83 million quarter-over-quarter to where our investment capital is now $1.66 billion. A lot of that is -- the improvement is higher pricing levels for our portfolio with a little bit of accretive capital raising during the period. Our leverage at the end of the quarter had declined slightly to 7.96, our long-term capital. And the net duration gap of our portfolio was about 2.5 months. Our book value which I think is across the board in the REIT space is a positive for everybody. Our book value per common share increased 65 basis points. We ended the quarter at $13.88. Most of the improvement was increasing value to portfolio. Offset slightly with a little -- our swap book. But I'm just going to open it up for questions here in a second, but I just want to say a word about the recent passing of Mike Farrell, who was CEO at Annaly. Mike was a leader in the mortgage REIT industry, and was the person I think most responsible for the growth and acceptance of the mortgage REIT model. And I just wanted to say thank you to Mike, and we'll miss your leadership and our sympathies go out to his family and coworkers. So with that, I'll open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Bose George of KBW.

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

Can I just start? I just wanted to get the spread on new investments, where you're seeing them?

Andrew F. Jacobs

Sure, Bose. Right now, in this environment, the type of securities we're looking at, we're probably talking about 125 to 135 basis points. So on a levered return basis, assuming 8x leverage, you're kind of looking in the 12% area.

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

Okay. And then just in terms of the yield versus the cost of funds. Is the cost of funds in that calculation? You're assuming the cost of funds pretty similar to what you guys have now that's mid-50s?

Phillip A. Reinsch

Well, no. Looking at current market conditions, 2-year swaps are at about 40 basis points, and repo is between 40 and 45. So I think 40 is a pretty good proxy for new purchases.

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

Okay, great. And then just on your book value or on asset prices, whatever, since quarter-end, just can you give some commentary on that, please?

Andrew F. Jacobs

Well, the ARM market, in general, I would say longer reset hybrids are probably down 0.25 of a point or so. And shorter resets, the securities are probably unchanged.

Operator

Our next question comes from Steve Delaney of JMP Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

Andy, and by the way, the revised disclosure on spread, much appreciated. I think it puts you in line with others, and we were able to get to your real spread before, but I like the way you've laid it out. It's much clearer. Thank you for that. Just any comments you could give us based on what you are seeing -- expect? You had a pretty good jump up in CPR 3Q over 2Q. Obviously, seasonality may be a little hard, too. I'd love any thoughts you have about third quarter move. I think that was expected. But most importantly, what are you guys thinking about internally as far as the likely change in CPR in the fourth quarter?

Andrew F. Jacobs

Yes, sure. Steve, I'll take that one. We already have October prints out, right. And so generically, in ARM space, if you just look at it month-over-month from September to October, ARM speeds dropped 3 to 4 CPR in that first month. If you look at speeds for the entire third quarter versus just that 1 month, they dropped 1 to 2 CPR. And having said that, they should tick back up in November and December, as between QE3. And then, originators try and close loans before the GPs go up, you'll see a tick up in November, and it should moderate in December. And so, looking at our book, where it was 18.7% CPR in the third quarter, if you just look at what's going on in the near term and what forecasts are for ARM speeds, I think high teens to 20-ish area is kind of a pretty good proxy for a portfolio like ours.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay. So maybe a 10% increase, something in that order?

Andrew F. Jacobs

Yes. I mean, we're really not -- if you look at our seasoned short-reset securities, we're not seeing a lot of speed pressure on those. It's mainly our newer issued longer-reset securities. And so, kind of what you're seeing in those types of securities, our seasoned book is kind of printing mid-teens and the newer stuff is kind of mid-20s. And we don't see a big spike from there.

Andrew F. Jacobs

And keep in mind, when Robert was mentioning the newer stuff printing at a higher speeds, it's not that were buying those with the expectation of them being like our seasoned book. We're buying them with the expectations they're going to ramp it up, be running off higher. So that's built into the calculations. And otherwise, we wouldn't be looking for them. They would be hurting our values much more. But we're expecting those to do exactly what they're doing, run off higher.

Robert R. Spears

Yes. If you look at the state of the mortgage banking industry right now, and I know a lot of this has been discussed in detail, but if you look at what happened to fixed rate pass-through yields in the third quarter, let's say they dropped 50 basis points, mortgage originators, the big banks, only passed on about 1/8 of that, and they can yield to consumers. And the primary to secondary mortgage spreads out there are running at about 135 basis points. And so, yields that consumers are getting are very sticky right now. And I think there's still some capacity issues in the mortgage banking industry. There are also some issues about them not wanting to bring rates down because they don't want to pool 2.5, 30-year security. The pooling dynamics are not very favorable for that trade right now. They don't want to carry a bunch of excess servicing. Now having said that, they are hiring people, but I still think there are capacity issues in the mortgage banking industry that are going to prevent a massive spike in prepayments.

Steven C. Delaney - JMP Securities LLC, Research Division

Makes sense, and that's good color. I just have one final thing. You gave us good detail kind of on the new investment and where that's been focused in the longer-to-reset paper. I understand the dynamic there. But in the -- sort of your legacy book, I'm just curious if you're seeing those assets you certainly don't seem to be inclined to sell any of those despite the run-up in prices. I think you had 0.5 point price gain in the third quarter. I'm just curious if you're seeing any flow in terms of pieces or blocks of actual short reset ARMs, and you offered, in response to Bose, an indication sort of what spread you could get on the stuff you have been buying. But Robert, do you have any sense that if you saw a block of short reset ARMs, some sense of where you could book that in terms of yield and spread on the short stuff?

Robert R. Spears

Yes. They're slow in that. It's not like a massive block size on a daily basis. But basically, those securities right now, if you just look at yields, a lot of them are priced at below a 1% yield. And so obviously, on a levered basis, if you're repo-ing it at 40, you can't make that trade work from our standpoint. Having said that, given where our basis is, they're throwing off very nice yields for us. And so, kind of the buyers of those type securities, more often than not, are unlevered money managers that are just looking for cash surrogates that have predictable speeds. But right now, some of those are being priced to a 10 to 12 CPR, so that doesn't give you much cushion for an uptick in speeds. And if they just go from 8 to 15, and you pay 1 out of 7 for those bonds, you get crushed. And so, it's a very good carry instrument given our basis, but we can't make them work given where they're trading right now.

Steven C. Delaney - JMP Securities LLC, Research Division

Got it. That makes great sense. And what would you estimate on the stuff you did buy, sort of the average remaining term to reset, which I assume this sort of -- the higher initial pay coupons or one of the things that's driving your 2% yield on those. But I was just curious, how much longer are you going to...

Robert R. Spears

Yes. I mean, it's a combination of new issue and seasoned securities. We still are not going out much beyond the 5/1 space. We bought some roll-down 7/1s, but we're not any longer on the curve than we have been in the past. And at the same time, if you noticed our swap position, until we bought $1.2 billion, roughly in securities this quarter, we put on $1.1 billion in swaps. And so at this point in the rate cycle, and I know the Fed is -- it looks like they're going to be on hold for quite a while. But we're being very judicious on the hedging front. And, if anything, you saw our duration gap come in about a month from last quarter.

Andrew F. Jacobs

But of that swaps that we put on, that Robert mentioned, some of those are -- the majority of them are forward starting swaps as well. So it's not just layered in, it's current pay today. Those are going to be something, I think as we said in our press release, those go -- those will begin paying -- begin paying beginning their 2-year period as far as the beginning of the third quarter 2013, so they're almost like 3-year swaps.

Operator

[Operator Instructions] And our next question is from Jackie Earle of Compass Point.

Jackie Earle

Just quick. Do you see a share repurchase program as a potential use of capital any time in the near future?

Andrew F. Jacobs

No. Obviously, we've made no announcement with that. But that's always just thinking about things you can do. But from the standpoint, I think what's key is what Robert's able to deploy capital at. I think those buybacks are kind a short term-type of perspective, and Robert's investing for -- the assets and the yields for a longer period of time. And from a total return, we've -- if Robert can continue to do what he's doing, we feel comfortable with running as we are, so that's it. But it's something we do, talk about at times. But nothing's announced.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Kelly Sargent for any closing remarks.

Kelly L. Sargent

Thanks, again, for joining us today. If you have any further questions, please give us a call, and we look forward to speaking to you next quarter.

Operator

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

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