Lisa Yahr - Head, IR
David Roberts - Chief Executive Officer
Jonathan Lieberman - Chief Investment Officer
Frank Stadelmaier - Chief Financial Officer
Stephen Laws - Deutsche Bank
Steve Delaney - JMP Securities
Boris Pialloux -National Securities
Mike Widner - Stifel Nicolaus & Company
AG Mortgage Investment Trust Inc. (MITT) Q3 2012 Results Earnings Call November 8, 2012 9:30 AM ET
Welcome to the AG Mortgage Investment Trust third quarter 2012 earnings conference call. My name is Christine and I’ll be your operator for today’s conference. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session. Please note today’s conference is being record.
I will now turn the call over to Lisa Yahr, Head Of Investor Relations. You may began.
Thanks, Christine and good morning everyone. Welcome to the AG Mortgage Investment Trust third quarter 2012 earnings conference call. Joining me on today’s call are David Roberts, our Chief Executive Officer; Jonathan Lieberman, our Chief Investment Officer; and Frank Stadelmaier, our Chief Financial Officer.
Before we begin, I’d like to review our Safe Harbor statement. Today’s conference call and corresponding slide presentation continued forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such statements are intended to be subject to the protection provided by their format.
The Company’s actual results may differ materially from those projected due to the impact of many factors beyond its control. All forward-looking statements included in this conference call and the slide presentation are based on our beliefs and expectations as of today November 8, 2012.
Additional information concerning the factors that could cause actual results to differ materially from those contained in a forward-looking statements are included in the risks factors section of the Company’s periodic reports filed with the Securities and Exchange Commission. Copies of the report are available on the SEC’s website at www.sec.gov.
Finally, we disclaim any obligation to update our forward-looking statements, unless required by law. With that I’ll the turn the call over to David Roberts.
Thanks, Lisa and good morning to everybody. We had a very productive quarter, so we’re very pleased to talk about it. We had extremely strong core earnings of $3 per share. We had three capital raises that were done very efficiently and were beneficial to our shareholders and our book value increased and we’re very pleased with the way the portfolio was positioned at the end of the quarter.
I want to make two comments on the importance of flexibility and how we view that. We continue to be very proactive in using the breadth of Angelo, Gordon platforms and Angelo, Gordon’s resources to construct the best risk reward portfolio from our point of view. Today our portfolio includes both agency book as well as a credit book.
In the future, it may include new originations of residential mortgages and it may include new originations of commercial mortgages as we continued to use the platform and our experience in the real estate area. So that’s point number one about flexibility. Point number two is related to core earnings and our dividend policy. In the past, we’ve talked about how our dividend policy follows directionally our core earnings performance. It is also important for you to know that we manage our portfolio, we manage AG Mortgage Investment Trust portfolio to achieve what we believe is the best risk adjusted return.
We do not have specific targets for core earnings. In fact, core earnings really are results of what the portfolio produces and the portfolio will change as conditions in the market change and our outlook changes over time. So we’re continued to be flexible not only in using all of Angelo, Gordon’s, and the investment teams resources to construct the portfolio, but we want to be flexible as well not to be locked in to producing a certain yield regardless of market conditions.
So with that, I will turn it over to Jonathan Lieberman, Chief Investment Officer to talk about the portfolio and what happened during the quarter.
Good morning, and thank you David, first I just wanted to express Angelo, Gordon and AG MITT’s sympathies for the difficulties of our citizens and our fellow Tri-state residents where hurricane Sandy’s damage in yesterday’s [Northeast]. We know the challenges faced by our fellow Tri-state citizens and we’ll actively support the recovery of our community. With respect to the third quarter performance, we are very very pleased with our performance and how the portfolio has setup going into the third and the fourth quarter, which we’re now halfway through.
The second point I want to make is I’m extremely satisfied that we now have meaningful portfolio allocation tension. Our pipeline of credit investment opportunities now requires the sale of existing positions to generate investable capital.
Third point is portfolio construction has resulted in strong investment performance during the second half of this year and we’re well positioned for 2013. I’m now going to turn to a presentation that’s been posted on our website, it’s always the same format as prior quarters.
Page 5, as we’ve discussed on our prior quarter calls our fundamental economic outlook is the genesis for our thought process on portfolio construction, asset allocation and hedging. Page 5 outlines our current outlook, which has not changed meaningfully from last quarter. The global macro environment continues to be challenging. US economy continues to remain muted by most measurable statistics. GDP growth was revised lower for the second quarter, labor market conditions, although improving, still remain challenging with above average elevated unemployment and on payrolls barely able to keep pace with natural population growth.
So the election is behind us the looming fiscal cliff will render virtually impossible any chances or near term meaningful job creation in the economic recovery in our view given that it will undoubtedly be concretionary in the fiscal sense.
Median income in United states remains at its lowest point since 1995 about the same time a younger generation is entering a challenging labor market, well saddled with high levels of student loan debt. The economic situation in Europe continues to deteriorate in our view despite apparent easing in market concerns over the debt crisis in fact unemployment rate on the continent confident remains at historical highs and the managed depression in the southern part of the Europe appears to be spreading to the core economies.
Europe continues to be one of the largest economic zones in the world and given a deepening recession and unstable government budgets, in that region it’s woes will continue to weigh on global macro environment for the foreseeable future. So not withstanding this general malaise in the US economy and worldwide markets. The one area that we are consistently favorable on is housing and commercial real estate, it’s showing signs of strength and stability in many areas across the country. Improving sales volume and falling distress inventories have created some optimism and the marketplace is gradually becoming much more constructive.
Home prices have posted their largest increase since 2007 and this positive trend seems to be firming up more than the experience in 2010. While we are optimistic on housing than any other sector of the domestic economy we’re still not calling for a sharp short-term recovery in home prices and we remain mindful of the potential land mines in the form of the fiscal cliff and the European debt crisis and the continuing pressure on wages in the United States.
With that in mind we really think that a portfolio of construction that we have is ideally suited for this environment and we think that interest rates are likely to remain low certainly with the reelection of President Obama through 2014 and maybe 2015.
So moving to page 6 of the presentation, there’s a quick snap shot on the highlights quarter-over-quarter and the changes in rates in credit markets, prices and all appreciated in response to QE3, although since quarter end the sector has given back some of the gains. The rallying credit continued over the third quarter on the heels of very strong technical’s and improving fundamentals as I earlier discussed. Volumes remain robust across structured products and our teams have been able to add attractive credit positions and we’ll continue to allocate to ABS, private RMBS and CMBS.
Now before we turn to page 8, 7 and 8. I’d like to review a little bit about our portfolio of construction as of September 30, and highlight our portfolio of constructions as I mentioned our economic outlook is one of the building blocks where the core of the portfolio, on last quarters call we mentioned that we thought that the economic environment QE3 was more likely and thus had positioned the portfolio to withstand a much lower interest rate environment. This has certainly played out.
At the same, we believe that it’s prudent to continue to construct a portfolio that mitigates different strategy risks and mindful of the ongoing European crisis, which we think still has a lot of room to run and the potential for extended periods of subpart growth domestically.
Given our third quarter capital raises the portfolio grew quite meaningfully from just under $2.7 billion to just under $5 billion. The portfolio today stands a little over $5 billion and that’s as of -- I said literally as of yesterday.
Quarter-over-quarter our agency portfolio increased over 80% from current face amount of $2.5 billion to $4.6 billion. The capital raises also allowed us to continue to allocate to the credit side of our portfolio where our current face more than tripled from just under $500 million to over $1.6 billion. On a gross asset basis the credit book grew from approximately 16.4% to 19.7% of our overall portfolio.
Today our credit book is slightly over 20% of our gross assets. We will continue to shift the composition of the credit book as we see opportunities and with further sales of lower yielding agency and ABS and other credit assets.
I would like to now spend a few minutes and sharing some additional detail on our agency portfolio, given our expectation of lower, or longer interest rate environment, we have continued to position ourselves in bonds that we believe that will exhibit favorable prepayment behavior. These include lower loan balance, ones with that represent about a third of our portfolio as well as HARP pools and then new production current coupon where there is really limited incentive for those mortgages to refinance and prepay.
When we look at newer production bonds we also layer in an analysis of geos - geographies, third party originations which generally have a higher tendency to prepay and then service or behavior, where services may aggressively try to refinance MSRs to protect their own book. Page 9 of the presentation includes graphs highlighting how service or behavior can impact prepayments.
Over the quarter we did take profits on select positions that has experienced significant run ups in price especially in some pay up pools. We also allocated a modest amount of additional capital to our inverse IO book, where we continue to focus on core protected stories. Our aggregate CPRs remain muted with the book printing at 6.2% CPR for the third quarter and 6.8% for the month of September.
With respect to our outlook on prepayments we believe the risk remains skewed towards faster prepayments in the near-term. Mortgage rates remain in the context of their historical lows, with the Fed purchasing $65 billion a month of MBS. They are unlikely to rise meaningful in the immediate future. The widening of the primary secondary spread does attest to the visible capacity constraints in the mortgage origination channel.
Over time however we believe that the industry is hiring training loan officers and we expect these constraints to ebb. While policy risk is arguably lower than it was six months ago given the improving housing market it still remains a conciliation and we may remain very active in Washington DC, so that we are certain of what is on the minds of decision-makers.
Turning to the credit side of our portfolio, and this is set out on Page 10 of our presentation. You’ll see that we have successfully executed our strategy of increasing our deployment of capital into credit quarter-over-quarter as well as with our new capital that we have raised. While we have added further exposure to prime hybrids and prime fixed rate bonds we have also added additional all day exposure and meaningfully increased our CMBS investments.
We have always believed that our ability to leverage the Angelo, Gordon commercial expertise benefits us as we selectively deploy capital in primary and new issuance transactions. More broadly speaking the depth and breadth of the AG platform continues to see and source a robust set of opportunities. I must highlight again how our platform continues to allow us to rotate and deploy capital in an accretive manner despite broader based spread tightening and lower yields generally in the fixed income markets.
Activity levels during the third quarter remained quite elevated, and I would like to emphasize that our team of 17 investment professionals is dedicated to working hard as ever, to continuing to source assets in order to best position MITT to continue to deliver strong results to our shareholders.
On page 11, I’d like to highlight the growth experienced in our capital base. Frank Stadelmaier, our CFO will go into more detail, but we believe that this has allowed us to continue to expand our portfolio further diversify it in a meaningful way and also bring down the costs for the overall corporation moving forward.
Turing to page 12, overall portfolio leverage at September 30, stood at about 6.06 times. Our leverage as of June was 6.79 times, the decrease over the quarter is attributable to our increased allocation to credit securities, comparative to other competitors in the field our non-agency RMBS book is more heavily weighted towards prime and short duration securities and so, that is of the attribution for why we run slightly higher leverage in the non-agency RMBS world than our competitors. We are very comfortable with our leverage within our target ranges and this allows us flexibility to respond any attractive opportunities in the market.
As to liquidity, at quarter end we had excess liquidity north of $250 million, and given our cautious macro views, we believe its prudent to retain excess liquidity is to take advantage of opportunities as well as to meet any macro challenges.
Moving on to the repo of and the financing side, the company experienced no challenges on the funding side we continue to extend the maturity of our repo book as we typically do at this point in time to over 45 days. We will continue actively manage the maturity of our book as we approach year end and the fiscal cliff.
As we’ve discussed in prior presentations, we have 26 counter parties, we’re currently working on our 27 counter party. We’re very comfortable with the amount of financing. We are making a concerted effort to increase the amount of term leverage that we have as part of our portfolio. And to put in place, additional facilities for our credit assets. So that will be a big focus over the next 3 to 6 months for the company.
On page 14 moving to our hedging analysis, we are currently 53% of our total agency repo book. It had hedges and swaps we continue to rely predominantly on swaps for hedging. To repeat what I’ve said on prior calls we are very comfortable with our hedge ratios and the market value risk in the current rate environment. We continue to operate in spectrum of 40% to 60% this hedge ratio is up slightly quarter over quarter most of it’s attributable to our selling agency securities as well as adding in some new longer dated swaps.
We also pushed out the duration of our swaps. Should we see any change in the potential path of interest rates you’ll see that reflected in our hedge ratio? We remain in line once again with swaps and MBS derivatives. With respect towards duration gap and Frank Stadelmaier will go into more detail. Our duration gap stood at 1.8 years at the quarter end. Prior to or during the quarter Credit Suisse, our model provider did update their model which reflected slower pre-payments and refinance behavior or borrowers during the quarter, which contributed to the extension of our duration.
Among the changes is incorporated into the model we saw changes in turnover rate, prepayment differential, for refinance versus purchased money loans, in a post HARP kind of world, changes in the mortgage industry as well increases in the [G fee] and loan level pricing adjustments by Fannie and Freddie.
In closing, we’re very-very pleased with our third quarter performance of our portfolio. I really I’m extremely satisfied that we have meaningful portfolio allocation [attention]. Our pipeline of investment opportunities requires the sale of existing positions to generate investable capital. Third point portfolio construction has resulted in strong investment performance is going to be second half within our risk adjusted guidelines, and we’re well-positioned for 2013.
With that I’ll turn the call over to Frank Stadelmaier, who will discuss our financial performance.
Thanks, Jonathan, good morning. This quarter was a busy one for us in three separate capital market transactions we raised $328 million and used the proceeds to grow assets from $2.7 billion to $4.9 billion. As a result, there’s a lot going on in the quarterly numbers, I’ll give you some of the highlights here.
For the quarter we’ve reported net income of $61.2 million or $3.10 for fully diluted share. We reported core earnings of $20 million or $1.03 for fully diluted share. Versus $13.5 million or $0.86 per share in the prior quarter. The increase in core earnings was driven primarily by three factors, each of which I’ll further detail in a moment.
First the net interest margin earned on a portfolio increased period over period, second was the accretive nature of our preferred offerings, and third was the positive retrospective adjustment we recorded. These increases were offset by the timing of deployment of proceeds raised in our capital offerings which resulted in us being marginally under-deployed relative to prior quarter.
The weighted average net interest margin earned during the quarter was 2.5% versus 2.6% in the prior quarter. This increase was attributable to the growth in the credit portion of our portfolio, from 16.4% of gross assets to 19.7% of assets. This is offset by decrease in NIM of our agency portfolio which was driven primarily by the deployment of equity proceeds into agency assets with lower yields [that have been] previously available.
Next, I’ll discuss the effects of our preferred offerings. In august we completed an offering of 8.25% series A preferred to the stock which resulted in net proceeds to us of $49.9 million. In late September we completed an offering of 8% series B preferred stock, which resulted in net proceeds of $111 million. The proceeds from each of this offerings was deployed into assets with the yields in excess of the dividend rate. This differential flows directly to the common share holders. The choice to raise preferred equity relative to the common stock contributed $0.04 per share to core earnings.
Now I’ll discuss the retrospective adjustment. We accrue interest using the level yield methodology that incorporates of forecast of prepayments over the remaining life of the assets. We derive our cash flows from the CS Locus model.
During the quarter the forward CPR in the model was updated which slowed down the projected CPR rate for certain of our prepayment protected [stories]. Additionally our actual CPR has continued to be slower than the forwards looking CPR, that is used in the model. These were offset by projected changes in CPR due to the decreasing interest rates.
All this resulted in $0.06 per share retrospective positive adjustment into core earnings. Exclusive of the retrospective adjustments core earnings was $0.97 per share versus $0.91 per share in the prior quarter. In addition to the $1.03 of core earnings our GAAP net income of $3.10 included $0.21 of realized gains on our portfolio and $1.86 shares of unrealized gains. The gains came from both agency and non-agency collateral both which outperformed equity after the announcement of QE3.
Since quite a bit happened during the quarter I’d also like to highlight a couple of statistics at 9/30 to give you a sense of the earnings capacity of going forward. Our net interest margin was 2.4% on leverages 6.06 times, we expect management fees and operating expenses will each continue to be around 1.5% per quarter.
Our book value increased $1.93 per shares during the quarter. This increase included the net income earned during the quarter offset by $0.70 dividend we declared during the quarter. Additionally, the August common stock offering was accretive to our 630 book value by $0.05 per share. During the quarter our undistributed taxable income increased by $0.02 per share to $1.19 per share.
Our undistributed taxable income has come primarily from the gains of sales of securities. The undistributed earnings continued to be invested in securities of the attractable yields and the undistributed taxable income provides us additional flexibility while considering the future dividends. We’ll now like to turn the call back to the moderate during the questions.
Thank you. (Operator Instruction) The first question comes from Stephen Laws from Deutsche Bank, please go ahead
Stephen Laws - Deutsche Bank
Hi, good morning. Congratulations on a great quarter, the numbers were great and there is a credit sensitive asset mix was definitely larger than expected so nice job ramping outside out of portfolio. I guess first off as I think about the options you have outside agency, MBS, as you deploy capital or else you worked at reallocating capital. You know, can you talk about yields and your targets buckets in the portfolio today, especially what you’re seeing on new investments in the senior non agencies, you guys I think did target the senior securities there, and as opposed to see peers maybe a little bit more junior and that allows you to have slightly higher leverage, but I’m curious what yields are on new investments there?
You know I would first of all break it into what I would call commodity, credit assets and little bit less commodity oriented credit assets where our insight into the underlying loans or ability to source really differentiates our ability to find assets. So you a prime jumbo RMBS, you’re looking at somewhere between you know 4% to 5% or 5.25%. Risk adjusted for probably a 4 year to 6 year duration security, but we’ve been able to source selectively assets that can have 50 to an additional 100-150 basis points more yield in that type of prime asset.
It’s a similar story as you move around in the credit spectrum you move out a prime you’re basically, when you go to Alt-a, you can add the 50-75 basis point out to the generic commoditized product where literally, we could go in and we could add $100 million to $200 million of those assets in an afternoon, but if you’re much more selective and you’re able to into just source some more unique assets you can certainly pickup anywhere from 50 basis points to 200 basis points of incremental yield.
Okay great and then expanding on that with these non [ACF] that in the prepared remarks you guys mentioned, I believe some residential whole loans, and you said some other classes then a little later in the prepared remarks talked about terms financing markets and trying to not have a 100% reliance from short term recourse financing, are those two things related with any specific asset classes, we’re only willing to invest in a bunch of whole loans that you think you can turn around and securitize those, can you maybe talk about how you look at increasing option from asset side in comparison to when you might be able to diversify the financing?
Right I mean we have as on September we had $963 million of assets, equity invested, amortized cost, fair market value of assets allocated on credit side. We had one year facility in place with one counter party at $75 million, we are actively working on several facilities that range from 180 days out to 3 years that will allow us to diversify our financing and move away from short term financing or the credit book, we think that’s important as credit book grows in size and as the agencies portfolio potentially shrinks in size given the liquidity constraints of each market, although right now the credit markets are exceptionally liquid we still have to prepare for the point and time when those markets are more challenging,
On, in terms of whole loans we can procure reasonable facilities for whole loans of anywhere from 6 months to a year. We would be comfortable holding those securities in our facility of 6 months to year at attractive financing levels and we can certainly securitize those assets readily and turn them into [qceps] bonds which could be financed on an easier basis than the whole loans long term. Part of the strategy if we were to execute on raw collateral would be longer duration financing arrangements that would go hand in hand with the execution of the procurement of those assets.
Stephen Laws - Deutsche Bank
Right thanks for the color, so very nice to have those options for future investments. But I guess, one final question and I’ll drop off and get back in the queue if I have another one, I know it’s touchy to talk about your dividend but it’s always little tricky forecasting dividends for companies with large cushions of undistributed taxable income.
Can you guys maybe talk a little bit, and I know you can’t really talk and quantify the dividends going forward, maybe what goes into your – the board’s consideration and thought process, as they do establish that dividend with respect to where we see core earnings and what the cushion and how we should think about that going forward?
Hi, this is David Roberts. We really look at where core earnings are shaping up in the quarter that we’re declaring the dividend, what’s happening in the marketplace, what’s happening with the portfolio and you know the timing of it is typically when close to two thirds of that quarter are done. So we’re still a number of weeks away from making the determination for the fourth quarter.
And in terms of the cushion, we know we look at what our opportunities are in the marketplace and you know what makes sense over the long term for shareholders. So I know that’s not a specific an answer as you’d like but that’s basically our process and we try to be to use a word, I started off with, we tried to be flexible and look at everything and take everything into account at the point in time we have to make that decision.
Stephen Laws - Deutsche Bank
Okay great, well that’s still helpful so we would continue use quarter names as guidance as a rough guide there. Great thank you guys, very much for the time for questions.
The next question comes from Steve Delaney, from JMP Securities. Please go ahead.
Steve Delaney - JMP Securities
Thank you, good morning everyone and I echo Stephen Laws’ comments, great quarter. Wanted to talk a little bit about the credit side of the book. You’re one of the few hybrid REITs that has the ability to go both on residential side and the commercial and it appears you’ve obviously been - thus far you’ve found more value in legacy RMBS than in CMBS.
I was just wondering Jonathan if you could comment on how you see those two markets currently and if in fact you are even looking at say some of the, the mezz tranches on the new issue CMBS since there is actually new supply in that market as opposed to the on the RMBS market. Thank you.
Sure, Good morning, thank you for the question. We do look at new issue CMBS, we have found some assets there to be very attractive, the challenge had predominantly been on the financing side for CMBS that we may like mezzanine piece but putting in place the appropriate financing arrangements to allow us to achieve an ROE commensurate with the other asset classes, as the times held those back. And then we also have seen sometimes a little bit of overreaching on some of the new issue deals where we’ve disagreed with potentially rating agency levels or the credit determination of the counter parties.
The final point I would make is, there is historically more volatility on the CMBS side. So we are typically a little bit more cautious to make sure that we have the correct credit the correct liquidity situation and the correct financing in place, but we do like what we see out there today.
Steve Delaney - JMP Securities
I appreciate that and of course I guess some of those, when you’re looking at the new CMBS, you’re looking at 10 year paper which makes you have to be a little more cautious on your hedging as well, which effects your cost the funds.
Steve Delaney - JMP Securities
Jonathan, just one other thing, I think David Roberts mentioned this at the outset on home loans and I guess it’s ties also into the commercial market. Where are home loans I think are little more I guess, I’d say the markets a little more liquid or little more certainty the securitization market is a little more viable there? But we’re seeing a lot of it the commercial REITs continuing to be able to post maybe 10% to 11% coupons on mezz loans and I was wondering to like Angelo’s network of relationships, with banks, insurance companies et cetera, is that hyper paper represent an option and of course we recently just show will let’s see this way, we don’t have close transaction but there is rumors that Redwood will be able to get a CLO on not their home loan book but their mezz book, so I was just wondering if CRE mezz might be part of the type of products that David Roberts was alluding too,
Steve Delaney - JMP Securities
Hi, yeah, certainly, it certainly an option, we have a very large network on the real estate side of 45 operating partners, we have a very big net lease area as well, and then of course we are one of the largest players in the CMBS market, as you know. So that can produce a pretty robust deal flow for us, where we can pick and choose and see where we might be able to get an asset for the REIT that we think has really exceptional risk reward. So something that we’re certainly open to and I think it’s a good option and has a place in the portfolio.
Steve Delaney - JMP Securities
Well, thank you guys for the comments.
The next question comes from Boris Pialloux from National Securities. Please go ahead.
Boris Pialloux - National Securities
Hi, thanks for taking my question and great quarter, I have like two questions. One is regarding the leverage, is the leverage back to six time, is that going to be more stand out where you would actually decrease your leverage because you’re investing more in credit assets. And second is some of your peers are looking at outside – looking out side there was a mortgage backed securities, looking out MSRs and GSC credit investment, so just want to have your thought on this type of market?
Sure, in terms of the leverage, leverage for the third quarter at 6.06 was representative of where we anticipate leverage being given the current mix at quarter end, we are not able to nor do we seek to lever the credit piece of our portfolio as highly as our agency book. We are seek to maintain a certain amount of surplus liquidity to meet any sort of prepayment activity or change in price. As the credit piece increases or continues to increase we would anticipate that leverage would gradually also decline.
As I mentioned right now we are predominately fully deployed in all asset classes, and so that the really is very, very strong attention in the portfolio that if we want to make additional credit investments, we need to shade lower yielding assets in the book whether their agency or credit and then adjust our leverage accordingly.
The second part of your question, we are and have looked at any sort of truncation from the GSC to straight credit risk and when those transactions [REIT] and we will evaluate them and make a determination of their appropriate for the portfolio. With respect to MSRs we have looked at MSRs extensively we are very gratified that we did not make investments in MSRs six months ago because we would be looking at very sizable losses, unless we had the capability of refinancing our own borrowers. So in an environment we are basically we anticipate elevated prepayment speeds, unless you have the ability to REIT capture those borrowers, you have material risk of financial impairment.
Boris Pialloux - National Securities
Okay, thank you.
(Operator Instructions) The next question comes from Mike Widner from Stifel Nicolaus. Please go ahead.
Mike Widner - Stifel Nicolaus
Good morning guys. Let me ask you a little bit more about sort of durations and your hedging and in particular as you said the model exchange the durations were down and were change the CPRs and so your duration gap effective extended in the quarter, leaving you with about 1.8 year gap, does that change your view of the hedging and is there because of that longer duration kind of do you think about adding swaps or in general how do you think about that in the exposure that that you would add.
It’s Frank, I think the models are reasonable approximation of what it, but it’s just a model and it’s going to be subject to change going in the forward certainly that durations stretching out, we’ll make us think about that but I think we’re comfortable with the hedging levels that we have given the interest rate environment given the asset that we have, given the leverage that we’re running.
This is Jonathan, I think we did increase the percentage of swaps relative to our agency book quarter-over-quarter, I think it’s also interesting if you spread other REITs their portfolios and look at their asset mixes relative to their swap ratios and try to look at their duration gaps, we’re comfortable with our coverage of the portfolio we’re especially comfortable we’re also in the midst of rotating assets from the portfolio into less duration sensitive assets and I think there is certain factors that are incorporated in to this reasonable models and then there are certain factors that models unfortunately our retrospective in their evaluation and we do have pretty good insight into government policy, I think we have pretty good insight into our view of QE3 and if we had much more material hedges on we might be having a different conversation with you.
Mike Widner - Stifel Nicolaus
So let me go back to one of the first things, you just said, there is what you guys expect durations to realistically be and then there is what gets spit out of various models on the street. And frankly I think sometimes what gets spit out of any model can be a little silly and disconnected from reality, because that’s the nature of models particularly when you start getting into securities whether it literally has been zero, historical experience with the performance and we really have literally zero historical experience with the yield curve being where it is and all the other things that are going on in the world today. So I do appreciate the fact that the models are a guideline.
But that being said, from a chronological duration standpoint to put aside the changing price over changing market yield thing, the caller duration, actual chronological duration, CPR duration everyone will look at it. Most of the assets actually seem to be longer duration. I would suspect them to be longer duration than what your models are actually spitting out today and I think that is evidenced by the CPRs that you are getting of the so called prepay protected securities remain prepay protected and in fact durations, asset durations are probably actually longer for some of these guys, for some others it’s the opposite, but longer than what’s.
So just kind of wrestling with that particularly as you think about hedging. As you said things would have turned out different had you hedged differently going into the quarter, but now that the yield curve is actually flattened, we’re heading into the spring and this year maybe different but pretty much every year for the past four years we saw a sharp rise in the yield curve as the world decides today. This spring is going to be the one where things really take off, the world is going to get better and suddenly the 10-year treasury rates go from [1.8%] to 2.25%, and that can be a very different situation. So, I don’t know I mean putting all that together I mean how do you guys philosophically think about how to hedge this particularly after you get some nice book value gains how do you think about whether to lock that in or whether to just say hey we are going to go with our guidance and do what we think is most likely to evolve?
Mike I would just say personal, I am not sure you are locking in book value as much as you are locking in NIM. You maybe locking in potentially future losses on your book value if you are wrong on prepay speeds. So philosophically I think it’s a much more nuance conversation. We have sold in the last week some assets in the agency side because prepay speeds are either increasing or anticipated to increase. That locks in the game permanently and allows us to rotate that capital. We have not elected to remove any of our swaps when we have executed on those types of transactions.
The portfolio is a young portfolio, its CPR will increase over time. You has a 12 basis point movement yesterday in 10-year swaps, 10 maybe it was, was it 10 or 12, somewhere in that general vicinity and there is a high probability that it will continue to decline may be over the next couple weeks. We have 30-year auction this afternoon. We have a fiscal cliff. We have potentially some contraction in the economic activity. So I think it’s, there is a higher probability may be that prepayments will increase for portfolio.
We have a very low prepayment speed so our extension risk is not dramatic. We have probably I would say more probability of asymmetric contraction in the duration of our book than we do have a probability of our book really kind of extending out on us. So we are comfortable with the hedge ratio that we have currently. If we believe that rates will move dramatically, we will 50 basis points up we will execute accordingly and we have looked at adding [swap options] and other derivatives to protect book value and in many cases we found that the protection offered by these other derivative looks very good on paper, but that the economic value is pretty minimal when you strike your swaps at 250% to [275.3%] that really does not protect you against the tenure going to two in a quarter.
Mike Widner - Stifel Nicolaus
So thank you I appreciate that. Let me just follow-up on sort of one important element that you mentioned, you know something that has been lost a lot recently in the discussion of hedging is something you alluded to. There is hedging book value and then there is hedging net interest spread and for better or worse the way I tend to think about it is you have people that talk about durations that get spit out of models that are really about the price change versus the change in and so you look at your hedge durations and your asset durations and that basis, but that’s all about kind of book value hedging and that’s where the zero duration gap or whatever tends to work as a hedge, you know it’s all about the price changes, which you know as you point out is quite a bit different than saying we’re trying to hedge our NIM.
Just so you know that conversation has seemed to vanish with a lot of REITs lately particularly and this is my concern, particularly in the quest for preserving dividends and preserving spreads it sort of works to your advantage and I am not saying you guys in general, but industry more broadly, it works to your advantage to kind of understate the duration of your assets, so that then you can get away with under hedging the portfolio and therefore kind of preserving a NIM.
So I certainly don’t want to suggest that you guys are going that. It doesn’t appear to me that you are, but it does seem to be a little bit of a trend in the industry and just we are in a very unusual time, I know an unprecedented time in terms of MBS prices in terms of what the Fed is doing with QE3 and in terms of the asset. I mean, no matter how you just want to look at it. This is, there is not a lot of historical precedents to judge, how does this work when things change rapidly.
So again just going back philosophically that tension between hedging NIM versus hedging book value risk is an important one, and you talked a little bit about it, but just how do you do that when you are dynamically reallocating the portfolio particularly in an environment where asset prices move 300 basis points in the quarter and then you decided it’s time to sell. Then do you reallocate your hedges and – so that’s just a broad open-ended question, but…
Mike we agree with you that this is a very unique point in history. I think we have emphasized on prior calls that we think that this is historic point in economic history and probably the most challenging point since the Great Depression. I would highlight you that, our hedging philosophy is a function of our view on the economy and upfront we told you that we view the economy is quite muted.
We view, the world economy is quite muted and challenging and deleveraging at the sovereign level and the state level will have to occur and is yet to occur. That said, we also said to you that basically we think housing is one of the strong points of economy and we also said that we expect prepayment speeds to remain elevated. I mean, we expect it to remain elevated both on the agency side but also even on the credit side.
So that is not that nuance may not be picked up by many people, but at least what we feel from the data and what we’re seeing in the marketplace is that you may have prepayment risk in ‘13 than people anticipate and our hedge ratio is an attempt to basically mitigate that risk and not increase risk in the portfolio.
With respect to the NIM, we have a certain amount of the portfolio hedged. We also have the ability to move around a number of days that we have our repos in place, that further locks down LIBOR risk. We balance it by adding more floating rate assets as well, one-month and three-month adjustable assets to the mix, and so we won sensitivities both on the NIM side as well as book value and then we come up with tolerance bands that we’re are comfortable operating through. If we believe that the fundamentals are changing we are not wed to these philosophical points of these demarcation lines, we adjust accordingly. It’s very important to maintain flexibility in this environment and we are lucky that the Angelo, Gordon platform allows us and a tremendous amount of flexibility with our origination capability.
Mike Widner - Stifel Nicolaus
Well thanks guys. I appreciate the comments and color and agree that this is kind of an unprecedented time and good luck in negotiating through to as well as you have over the past couple of quarters.
At this time there are no additional questions. Please go ahead with any final remarks.
This is David Roberts, I would probably close by thanking everyone for their, both for their time and for the very good questions and dialogue. We appreciate it and wish everyone well for the remainder of the calendar year.
Thank you for participating in the AG Mortgage Investment Trust’s third quarter 2012 earnings conference call. This concludes the conference for today. You may all disconnect at this time.
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