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Executives

Joseph Lloyd McAdams - Chairman of The Board, Chief Executive Officer and President

Joseph E. McAdams - Executive Vice President, Chief Investment Officer and Director

Analysts

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

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

Anworth Mortgage Asset (ANH) Q3 2012 Earnings Call October 26, 2012 1:00 PM ET

Operator

Good afternoon, and welcome to the Anworth Mortgage Third Quarter 2012 Earnings Conference Call. [Operator Instructions] This conference is being recorded. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]

Before we begin, I will make a brief introductory statements. Statements made on this earnings call may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and we hereby claim the protection of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to any such forward-looking statements.

Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as statements containing the words may, will, believe, expect, anticipate, intend, estimate, assume, continue or other similar terms or variations on those terms or the negative of those terms. You should not rely on our forward-looking statements because the matters they describe are subject to assumptions, known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control.

Statements regarding the following subjects are forward-looking by their nature: our business and investment strategy, marketing trends and risks, assumptions regarding interest rates and assumptions regarding the prepayment rates on the mortgage loans securing our mortgage-backed securities. These forward-looking statements are subject to various risks and uncertainties, including those relating to: changes in interest rates; changes in the market value of our mortgage-backed securities; changes in the yield curve; the availability of mortgage-backed securities for purchase; increases in the prepayment rates on the mortgage loans securing our mortgage-backed securities; our ability to use borrowing to finance our assets and, if available, the terms of any financing; risks associated with investing in mortgage-related assets; changes in the business conditions and the general economy, including the consequences of actions by the U.S. government and other foreign governments to address the global financial crisis; implementation of or changes in government regulations or programs affecting our business; our ability to maintain our qualification as a real estate investment trust under the Internal Revenue Code; our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended; and management's ability to manage our growth.

These and other risks, uncertainties and factors, including those discussed under the heading Risk Factors in our Annual Report on Form 10-K and other reports that we file from time to time with the Securities and Exchange Commission, could cause our actual results to differ materially and adversely from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time, and it is not possible to predict those events or how they may affect us.

Except as required by law, we do not intend to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Except as required by law, we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements that may be made today or that reflect any change in our expectations or any change in events, conditions or circumstances based on which any such statements are made. Thank you.

I would now like to turn -- I'm sorry, I would now like to introduce Mr. Lloyd McAdams, Chairman and Chief Executive Officer of Anworth. Please go ahead.

Joseph Lloyd McAdams

Thank you very much. Good morning or good afternoon, ladies and gentlemen. I'm Lloyd McAdams, and I welcome you to this conference call, which we will summarize the company's recent activities, and answer your questions about past activities and our views of the future during our question-and-answer session. But first, I will briefly describe recent events, and then I will comment on our current plans.

During the third quarter of 2012, Anworth's net income to common stockholders was $20.5 million, which is $0.15 per diluted common share. Also during this period, our net interest rate spread declined from 127 basis points, 1.27%, or from 109 basis points or 1.09%.

Stockholders' equity available to our common stockholders at quarter end was approximately $1.056 billion, which equates to a book value of $7.45 per share. That is based on 141.7 million shares of common stock outstanding at September 30. This represents an increase from our book value of $7.19 per share at June 30. The unrealized gain component of our book value is $0.88 per share, which means that the balance of our book value is $6.57, and some people refer to this number as our historical book value.

The fair value of Anworth's portfolio of Agency mortgage-backed securities at quarter end was approximately $9.26 billion, which, as you know, can be assigned to 3 major categories of Agency MBS. The first category that we invest in is adjustable rate mortgages, whose interest rates reset within 1 year; number 2, hybrid ARMs, whose interest rates reset after 1 year; and lastly, a 15- and 30-year fixed-rate mortgage-backed securities, whose interest rates never reset.

The purchase agreement financing of our Agency mortgage-backed security assets, which was approximately $7.96 billion at September 30, 6.82x our total equity, which consists of common stockholders' equity with all preferred stock plus our junior subordinated notes, and it was 7.2x the common equity alone. Floating to fixed rate interest rate swaps was $3.09 billion, which represents approximately 39% of our outstanding repurchase agreement balance.

Anworth, as you know, is different from other mortgage REITs and that a significant portion of our portfolio, approximately 22%, consist of seasoned adjustable-rate mortgages, whose coupons will contractually reset within the next 12 months. For purposes of this calculation only, while we eliminate the amount of repurchase agreements, which finance these less than 1-year reset ARMs because of their reduced interest rate sensitivity, ratio of our swaps to our outstanding repurchase agreement balance increases from 39% to approximately 52%.

While the size of our swap position is a significant component of our balance sheet, I believe that positions average remaining term of 36 months is more significant. Management's current decision about the size and term of their swap position is probably the major determinant of our current rate of return, and therefore, our dividend yield. You should note that when determining the nature of a prudent hedging strategy, you take into account the specific characteristics of the assets, which we have invested in, amongst the 3 major categories of Agency MBS that I mentioned earlier.

Weighted average coupon of our portfolio of Agency MBS was 3.09% at quarter end. Weighted average term to reset of Anworth's adjustable-rate mortgage-backed securities was 36 months at quarter end. After adjusting for interest rates paid through the swap transactions, the average interest rate of our repurchase agreement liabilities was 1.04%, and the average term to interest rate reset of our liabilities was 436 -- 437 days.

The prepayment rate, or CPR, of Anworth's portfolio that occurred during the quarter was approximately 26%, and the amortized cost of Anworth's portfolio of Agency mortgage-backed securities was 102.92%, which is a slight increase from the previous quarter.

As to our current plans, I believe there are several important subjects. First, as I have described in my letter to our shareholders in our annual report for more than a decade, our earnings level is determined by 3 primary variables: first, there is interest earned, less interest paid, less the amortization of the mortgage-backed security premium, which we have purchased.

As we have reported yesterday for the third quarter, our net income, relative to the second quarter, was, in varying degrees, influenced negatively by each of these 3 variables: first, of course, was interest received declined as ARMs reset to lower levels and the new investment yield was lower than our current portfolio average; second is that borrowing cost increased as U.S. agency repo rates continue to rise; and third and lastly, the dollar amount of premium amortized increased, as our assumptions for future prepayment rates refinancing increased largely due to the Fed stimulus and the increased amount of premium on our books, as I referred to just a moment ago. Based on our current outlook, we believe that each of these variables is likely to continue this trend into the fourth quarter.

Our second subject, the increase in the unrealized gains component of our book value has been a significant beneficiary of the Federal Reserve System's program of aggressive acquisition of mortgage-backed securities and its multiple quantitative easing programs over the past several years. If these stimulus programs were to be reduced for whatever reason, or even if there was a hint that they will be reduced, I believe that there are parts of our portfolio which are now more vulnerable to a larger correction in price than others. Therefore, there is an increased likelihood that we may sell some of these highly appreciated securities that benefited from this Federal Reserve activity hopefully prior to the time it's obvious. This would generate our capital gains that we would then distribute to our shareholders and, of course, would reduce the current $0.88 per share of unrealized gain portion of our book value.

While we expect our operating earnings to continue to decline over the next few quarters, that is if the current environment remains unchanged, we expect that the potential realized gains either partially offset or even exceed this decline from net interest spread.

Third subject is that of the hybrid ARM market. These hybrid ARMs are becoming less available in today's mortgage origination markets. Even within this hybrid ARM sector, hybrids which reset within 3 to 5 years are becoming more scarce, with homeowners seemingly having a preference for longer reset hybrid ARMs. The effect on us will be a greater reliance on longer reset hybrid ARMs and various maturity fixed rate mortgage-backed securities.

Last subject I would like to discuss before the question-and-answer session, the Federal Reserve induced declines in interest rates, and that has resulted in lower yields on mortgage-backed securities and increases in our book value. We know from our experience managing Anworth for the last 14 years, the strategy of gradually and intentionally reducing leverage temporarily will allow us to increase leverage at a later time when mortgage-backed security yields are higher.

Increasing leverage at times like the current solely for the purpose of a few more cents of earnings, in our opinion, requires a considerably increased risk with significant capital losses in the future. So as various of our assets repay principal, we will attempt to maintain the leverage and interest rate sensitivity near what we think are the appropriate targeted levels by purchasing mortgage-backed securities to what we believe will be attractive prices. Or, of course, if those are not available, we will be repurchasing our own shares if we're unable to purchase those types of securities at attractive prices.

So what I would like to do now is tell you today that with me are Joe McAdams, our Chief Investment Officer and our Director of the Company; Thad Brown, our Chief Financial Officer; and Mr. Chuck Siegel, our Senior Vice President of Finance. We will now turn the meeting over to Amy, our conference operator, to begin our question-and-answer session.

Question-and-Answer Session

Operator

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

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

The prepayment number that you reported this quarter, was that fully driven by prepayments, or just curious how much of that is driven by sort of your future expectations of prepayments?

Joseph E. McAdams

This is Joe. The amortization of premium that we reported is driven by our expectation of future prepayments, and that doesn't increase quarter-over-quarter based on the increase in some of our forward assumptions. But I would think the effect was fairly similar to the sort of proportional effect of the average CPR in the portfolio increasing from 24% to 26% quarter-over-quarter. And I don't think there was a big difference between more of -- if sort of a proportional method of amortization versus our method of using longer-term prepayment assumptions for the quarter.

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

Okay, that's great. Yes, just wanted to clarify that. And then just on spreads on new investments, can you just give us a little color there?

Joseph E. McAdams

Sure. The securities we purchased during the third quarter included a mix of hybrids, as Lloyd mentioned. Probably the predominant class of hybrids we have been purchasing recently have been 7 1 hybrids, with some 5 1 and some 10 1 hybrids as well; secondarily, the purchase of some 15-year fixed-rate mortgages. The average purchase price was a little north of 1 04 during the quarter, and the yield after our expected premium amortization would be approximately 1.65 for the quarter. If you take into account repo rates and swaps, our feeling was the spread on new investments made during the third quarter was expected to be about 110 basis points, which was very similar to the average interest rate spread on the portfolio as a whole. Now into October, we have had a bit of -- a small bit of a reversal in the appreciation of some of the Agency MBS we buy from September 30. So -- but at the same time, at levels that are lower yielding and higher price than where they were during the third quarter on average. So we would see yields on assets about 10 basis points lower and only a relatively small decrease in financing cost, because the decrease in swap rates we've seen has been largely offset by about a 4 or 5 basis point increase in where repo rates are today versus the third quarter on average. So I would see right to mid-October snapshot at spreads, it's closer to 100 basis points versus 110.

Operator

Our next question comes from Jason Stewart at Compass Point.

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

Could you give us a little bit more color on your thoughts behind repurchasing shares, and maybe some color as to how you're thinking about the economics of that transaction versus making an incremental MBS investment?

Joseph Lloyd McAdams

Sure, this is Lloyd. Our basic approach is that we are interested in being a long-term participant in the mortgage-backed security industry and providing a very attractive return to our investors. The returns from Anworth over the last 14 years, even at the current relatively low stock price, is about 9% a year compounded, which is a rate of return that most hedge funds were unable to achieve during that 14-year period. So we believe that we have a management process that works well for us. One of the keys to that management process is to have the discipline to become defensive and intentionally cut your dividend yield when you think the risk is great before other people see it or it is obvious to most people. We wait until most people think that interest rates might go up for whatever reason. The opportunities to become defensive are great, and the potential for large capital losses are very, very large. That said, we would like to be taking our interest rate exposure down, taking our leverage will come down because we think that interest rate risk are increasing rather rapidly in spite of the fact that no one wants to talk about it. That said, shrinking the capital base of our equity portfolio, or the equity capital of the company, will clearly cause us a problem by having to liquidate even more mortgage-backed securities to bring the leverage down to the level we want it to be. We have -- as you know, whenever I have seen mortgage-backed security investment opportunities at levels that I didn't think were particularly attractive over the next 6 to 12 or 24 months, we have repurchased shares in lieu of making those investments. That's always been our approach, and that will be the approach we have going forward. One of the things that you learn is the very time that you were supposed to be defensive investing in a mortgage REIT is usually the time that your stock price is at the lowest level always makes it difficult. Usually the time that your boast to be the most aggressive is when investing in a riskier portfolio is interestingly the time when your stock seems to be the highest. It seems that would be just the opposite, but -- given how capital market theory works. But the bottom line is that isn't the way it has ever been in my knowledge in mortgage REIT business. And so when it's risky environment, stock trade at premiums the book because the dividends are very high. And when it's -- you want to be in a conservative environment and your dividend is lower and you have a very much more defensive portfolio, surprisingly, the stock actually trades below book value. I can't deal with the fact that it's contrary. So that's what we'll be doing going forward. There's some very specific rules about how we repurchase the shares. They're not the most friendly toward companies. For those that don't understand how we do it, if you see stock trading in the first 30 minutes of the day, it's not Anworth repurchasing its shares, because we're not allowed to repurchase shares the first 30 minutes of the day. We're also not allowed to repurchase shares in the last 10 minutes of the trading day. So we will have no impact on the opening price, we will have no impact on the closing price. During the day, we are allowed to purchase shares so long as -- to keep it simple, we're not buying on the uptick or that we're not buying the price that causes the stock to go up because the Securities and Exchange Commission is concerned that during our stock buyback program, we would actually make the stock price go up. And lastly, since we've done this enough in the past, I give you the most difficult part of the process. The 4 decimal point trading world that we now live in, where some people can only put orders in at -- on the cents, other people can execute trades at a hundreds of a cent. We choose to buy the stock at $6.08, even a relatively small order like 25,000 shares. I will tell you that the next thing that will instantly happen is the algorithmic traders will offer to buy the stock at $6.0901. And we will be sitting on the sideline watching the stock trade supporting the algorithmic traders. So repurchasing shares is difficult. It can be done because we've clearly done it in the past, but we do it only when we think that the alternatives to getting the proper interest rate risk, the proper convexity risk and leverage multiplied times duration, we want to target all of those areas, and if the only way we can do that is to purchase shares, we will do it. We do not purchase shares on some theory that investors would like to sell their shares, so they would like Anworth to either support the stock price for them or buy their shares back from them directly. That is not the purpose of our share repurchase program. It is designed to help us build a portfolio whose risk-reward characteristics are precisely what we want them to be. And that's been our policy for many, many years, and I'm sure, I would assume, it will continue to be our policy in the future, unless the Board of Directors gives us a change of mandate.

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

Okay. That's great color. Maybe just make sure I understand what you said, because I think I completely agree with you. Your portfolio's very, I guess, at a lower risk profile than it has been in the past, operating at lower leverage, and yet your stock trades at an 18-plus percent discount to book value and those don't foot and they certainly don't foot with the ability to put capital out on an incremental basis at 18-plus percent IRRs. So is that, in a very quick summation, a fair synopsis?

Joseph Lloyd McAdams

I think it's fair. I will -- you said, to put capital out at 18% internal rate of return, but Joe just mentioned what we think the proper spread is with the proper degree of hedging, and it's -- he said something like 100 basis points. So with 6 or 7x leverage, 100 basis points adding in the equity, that's nowhere near 18%, but I don't know. And all I -- my other observation will be is mortgage REITs, even back in 1998 when we started, have historically seem to trade off of dividend yield not return, and not even something as rather complicated as risk-adjusted dividend yield. Now that has never really seemed to be part of the equation. So a very conservatively managed mortgage REIT, meaning almost fully hedged, no more risk than a mutual fund will probably trade at a discount to book, whereas the mutual fund would trade at book value.

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

Okay, and one last procedural question. You had 2 million that you authorized to repurchase back in October of last year, and I think you bought back around 835,000. Is that remaining authorization still active or do you need the board?

Joseph Lloyd McAdams

Yes, it is. I'm sorry to interrupt you, but yes, it is. And we also have -- we have various -- we have a fairly large number of investors who reinvest their dividend in the company and receive a very slight discount to the market price because we always encourage investors if they don't need the money to live on to redeploy the dividends into the company. And we don't shut it off just because the stock went down. We consider it a right that a shareholder has, it's not, we let people buy shares only when the stock is high. We let them buy shares when the stock is high, low and in the middle, and the board has also authorized us to repurchase all of those shares in the open market anytime we want to. Hopefully, we'll get to buy them back at lower price than the company sold them.

Operator

Our next question comes from Stephen Joswick [ph], private investor.

Unknown Attendee

Can you tell me, are there restrictions or blackout periods on the share repurchases, such as previous to a dividend or earnings announcement?

Joseph Lloyd McAdams

Thank you very much. There are daily blackout periods. The New York Stock Exchange and the SEC have their own blackout periods. As I mentioned, it's the first 30 minutes of the day and the last 10 minutes of the day. And although I've never read it, I've always assumed that the after-hours trading was also a blackout period, but I don't know if they've ever officially commented on it. So I hope that answers the first half of the question. The second half of the question is actually relatively vague. I don't know a black-and-white rule as to -- was I allowed to buy back shares of the company stock just before this earnings call started? Am I allowed to buy back shares of the stock just after this earnings call ends? Clearly, material information is being disclosed that was nonpublic information prior to our saying it. And I've always used the judgment that in spite of whatever the rule is, if the company has any type of significant material nonpublic information, we do not repurchase the shares. And that has meant that some periods of time, because I don't want to have anyone ever say that we bought some shares and the next day, we said something that caused the stock to go up 10%. I don't think that's appropriate for the people who unwittingly sold us the shares not knowing something that we knew. So I don't know if that's a very specific rule or not because clearly, repurchasing the shares is for the benefit of all the company's shareholders. But I always take the rather conservative approach to that type of item. So that is the policy that we have, whether it's the written policy and some regulation, I'm not sure.

Unknown Attendee

Okay. And would your repo lenders be indifferent to you repurchasing common shares versus redeeming an equal dollar amount of the Series A Preferred. And I realize right now, you're still got a little bit of positive leverage on that Series A. You're real close to being break even on it.

Joseph Lloyd McAdams

Thank you very much. For those people on the call who are not familiar with the Series A Preferred, we issued it about 8 years ago, I believe. The coupon rate is 8 5/8%. It is -- we can call it any day we want to, which is, I think, the basis of the question. It's trading at a price above the call price. We can also, through our direct stock purchase plan, could actually issue more shares because we have a shelf registration to issue more shares of that preferred. So -- but the question is, what do our repo lenders, would they consider it to be any different between the Series A Preferred -- perpetual preferred stock and the common? I believe the answer, and I'll have Joe speak to this also, is no. They don't like us shrinking our capital base. They consider our capital base as their additional collateral that they need to consider us a worthy borrower and worth the lowest interest rate available. So they would certainly not encourage us that to do that at all. Joe, do you have any additional comment?

Joseph E. McAdams

No, I don't. I think given the size of the preferred as well as the fact that it is a perpetual preferred, there would be no adverse view from the counterparty standpoint of whether our capital base got smaller because of stock being repurchased or preferred. But as Lloyd pointed out, if there was a significant reduction in our capital base, that could have an adverse reaction from our counterparties and the credit lines we have extended.

Unknown Attendee

Okay. And then you mentioned about selling off some securities at gains. Would you be required by the REIT rules to distribute those gains, or do you have the tax losses to offset these and then you wouldn't have to do so?

Joseph Lloyd McAdams

We're not required to distribute them. But it's our belief that, that income that we would have earned from the capital gain is income that has been earned by the company and the shareholders would have received in due course. The principal reason we made reference to, in fact, telling you that this might occur because for those who followed Anworth for low these many years, know that we do not have a sort of a standing program of selling securities at a gain because here, we think that the Federal Reserve has entered into activities. I don't know what everybody thinks about the Federal Reserve, but they've entered into activities, which clearly have caused the values of mortgage-backed securities to increase, that the overall economic environment, you would say, doesn't justify. And certain types of mortgage-backed securities, in our mind, many of which we own, have increased significantly over and above where we think they should be trading even relative to maybe some other securities. So that's our purpose, and we would intend to pay the dividend.

Unknown Attendee

Okay. But now if you had some tax loss carryforwards to offset those gains, then -- and you chose to distribute those anyway even though you didn't have to, then that part of a dividend would be a return of capital, wouldn't it?

Joseph Lloyd McAdams

I think that is correct. Actually, it would be treated as return of capital, and you would not be paying taxes on it in the near term.

Unknown Attendee

As long as -- but you folks do have some tax loss carryforwards to offset those, right?

Joseph Lloyd McAdams

We have some. I don't -- since I don't know the amount that's involved, there may be some left. I can't -- actually, I'm not really prepared to answer that question without looking at the income tax return.

Unknown Attendee

Sure, sure. Okay.

Operator

At this time, we have no further questions. I would like to turn the conference back over to Mr. McAdams for any closing remarks.

Joseph Lloyd McAdams

Thank you very much. We have appreciated the opportunity to share our thoughts about the past and our plans for the future. So all of our investors, either who are on the call or who read the transcript later, will have an opportunity to see what we're thinking. With that said, we welcome you to join us again next quarter at about this time where we will discuss our operational activities for the final quarter of the calendar year. Thank you very much.

Operator

The conference is now concluded. Thank you for attending today's event. You may now disconnect.

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