Hatteras Financial Q4 2008 Earnings Call Transcript

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Hatteras Financial Corp. (NYSE:HTS) Q4 2008 Earnings Call February 11, 2009 10:00 AM ET


Mark Collinson - Partner, CCG Investor Relations

Michael R. Hough - Chief Executive Officer

Kenneth A. Steele - Chief Financial Officer, Secretary and Treasurer

Benjamin M. Hough - President & Chief Operating Officer

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

Frederick J. Boos II - Executive Vice President and Co-Chief Investment Officer


Bose T. George - Keefe Bruyette & Woods Inc.

Michael R. Widner - Stifel Nicolaus & Co.

Gabe Poggi - Friedman Billings Ramsey & Co.


Hello and welcome to the Hatteras Financial Corp. Fourth Quarter 2008 Earnings Conference Call. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today's presentation. (Operator Instructions). Please note, this conference is being recorded.

Now, I would like to turn the conference over to Mr. Mark Collinson, CCG Investor Relations. Sir, you may begin.

Mark Collinson

Thank you Camille. Good morning everyone and welcome to Hatteras' fourth quarter and year-end earnings conference call. With me today are the company's Chairman and Chief Executive Officer, Michael Hough; the company's President and Chief Operating Officer, Ben Hough; and the company's Chief Financial Officer, Ken Steele. Also available to answer your questions are the company's Co-Chief Investment Officers Bill Gibbs and Fred Boos.

Before I hand the call over to them, please note that on this call certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management's current expectations and are subject to risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, expected, estimated or projected.

The following factors, among others, could cause actual results to differ materially from those described in the forward-looking statements. The company's limited operating history; changes in its business and investment strategy, changes in interest rates, interest rates spread, the yield curve or prepayment rates; changes in economic conditions generally, inflation or deflation, availability of suitable investment opportunities; availability terms in deployment of capital; the degree and nature of the company's competition, general volatility of the capital markets, dependence on the company's manager and the company's ability to find a suitable replacement if the manager were to terminate its management relationship; and other factors that are set forth in the company's prospectus for its IPO this year of the Securities and Exchange Commission and subsequent reports, including reports on Forms 10-Q and 8-K.

The content of this conference call contains time-sensitive information that is accurate only as of today, February 11, 2009; and the company undertakes no obligation to make any revision to the statements contained in these remarks or update them to reflect the events or circumstances occurring after this conference call.

So with that from, it is my pleasure to turn over the call to Michael Hough.

Michael R. Hough

Thanks Mark. And thank you for joining us today for our fourth quarter earnings call and thanks very much for your interest in Hatteras Financial. As Mark said our entire management team is on the call, so please be free to ask questions. But before that we would like to give you a quick summary on what went on during the quarter and how things have played out since.

I'd like to start-off by saying how pleased we are to be here in this capacity and to be trusted to manage a piece of your investment portfolio. We are happy that we could provide an investment in 2008 that was remarkably stable and it generated a nice positive income stream. Here the correlations across the investing universe were higher than ever and returns were generally negative.

We've been doing the strategy for 10 years at Hatteras and at ACM and from day one we've held at it as a diversification tool and 2008 was just another year to proved that. The past 12 months were obviously a year like no other and financial markets and especially in the markets that we operate in. I am very proud of the way our team together handled the challenges which often came quickly.

Looking back, I don't think there is one decision we made that I would change, without the benefit of apparent side because we dealt with the challenges proactively. We made our choices thoughtfully and we painted problems that could have been. '08 was a tough year for sure, in my view however the challenges we faced about the perfect foundation of caution and risk management with regard the company going forward.

Fourth quarter was obviously unpredictable. We have the arrival of a new government, the housing market continues to smelt down and the overall economy kept deteriorating. Surprisingly though from an operating sense, conditions did gradually improve as the quarter went on. Year-end prices this time were easier than last year end and really all of the quarter ends in between which was good to see and the transition in to '09 has been pretty much seamless from a counterparty and funding standpoint.

As you know and as we've said before, volatility create a disconnects over the course of the past year that we have viewed as opportunity, short-term borrowing rates and U.S. Treasury yields both declined throughout the year at all time low levels in December. But for the most part agency MBS yield remained relatively constant. This environment was the perfect set up for us to initiate and grow our portfolio to put us in position to realize an expanding earnings margin and to get the asset appreciation we would expect to get when conditions normalize.

So after initially funding the company in November '07, we raised $158 million of capital in January. We raised 256 million in our IPO in April. We saw another good market opportunity in the fourth quarter that led us to $197 million secondary offering that we priced on December 9th and closed on the 15th.

We are very pleased that the deal was well received and for the third time in 2008, we sold shares that were accretive to book value. In fact, if you look at the mark-to-market on our MBS and swaps for the year, you can see that the most of the book value growth we had came from the accretive premium paid for our shares in each of the offerings.

Within a week of closing the deal, it was amazing how fast the mortgage-backed securities market move once the Treasury started buying and the Fed effectively moved to a zero interest rate for the first time in its history.

Yields on agency MBS moved to lower with a combination of lower Treasury bond yields and the fact that MBS spreads to the treasuries tightened to levels we hadn't seen in a while. With the higher prices and heightened political job burning, we felt a higher level of uncertainty on how the government may choose to participate in the markets going forward.

Our response has been to increase caution and selectively invest in securities that we believe offer the highest combination of recurrent and defense that will protect against changing interest rates and prepayments. We want to be as flexible as possible in this environment and we feel that we're in a great position to take advantage of opportunities. Spreads are extremely attractive to an all time low cost of funds that are now priced in the fractions as well as the interest rates swaps.

So we continue to put capital to work at great ROE levels. As always though, we will not sacrifice our discipline and we'll be prudent in building the best; risk adjusted asset liability makes for the long-term.

So with that, Ken will briefly go over the financial results of the quarter before Ben spends a few minutes on the market and our portfolio.

Kenneth A. Steele

Thanks Michael. Good morning everyone. Once again I am pleased what turned out to be a pretty smooth quarter. the markets exhibited a great deal of unpredictability, but we were able to position ourselves in the way we wanted to given what we could and could not see coming.

Our GAAP net income for the quarter was 20.7 million or $0.73 per weighted average share including the affects of the additional shares sold on our December 15th common stock offering. Our REIT taxable income for the quarter which is the measure the dividend is based on was 26.7 million or $1 per share if you exclude the dilutive effects of the new shares.

The difference between our GAAP income and REIT taxable income relates to the reserve we took against our receivable for Lehman Brothers Inc. Due to the lack of clarity around the status of our claim and ability to recover after several months of effort by us and our attorneys, established a reserve against the full amount due to us from Lehman Brothers for a net loss of approximately 6.1 million.

We are continuing to seek resolution of this matter and a full recovery of our collateral. We really... there is some definite recoverability here at just at this point it's hard to predict what it is. Outside of Lehman, the results compared to third quarter were not remarkably different. Our net interest income fell slightly from the third quarter mostly due to increased funding costs. We also experienced some modest rate compression during the quarter as our yield was down slightly from 5.05%... from 5.08% the previous quarter and our average cost of funds moved up to 3% from 2.84% in the third quarter for net interest spread of 2.05% for the fourth quarter versus 2.24% in the third.

The main drivers on the increased funding cost can be attributed to three things. One, there was some hangover from the elevated rates from the end of the third quarter. Two, the funding stands we took over year, which increased average funding costs. And three, a larger swap position; had accounted for approximately 16 of the 19 basis points following our net interest margins. As I just mentioned the remainder of the difference was a slightly lower yield compared to the third quarter.

Our operating expenses were relatively unchanged, increasing slightly from 2.5 million to 2.6 million in the fourth quarter. In the fourth quarter we declared a dividend of $1 per share on December 1st for stock holders of record on December 11th. We elected to clear our dividend early in December, so we wouldn't dilute our then current shareholders' dividend by any new shares we might issue.

For 2008 we earned REIT taxable income of 85.2 million and paid out dividends of 81.7 million or $3.32 a share or dividend payout ratio of 95.3%. Our MBS portfolio also didn't change much from the third quarter, as we had an average portfolio size for the three months approximately 5 billion as compared to 5.1 billion in the third quarter. And our mix of assets was relatively unchanged as well approximately 70% Fannie Mae and 30% Freddie Mac ARMs.

Although our overall principle repayment rate fell to 7.84% the securities that did repay mostly tended to be the higher coupon and higher premium bonds leading to our slightly lower yield.

Financing which had become a key focal point for most of the year, remained a concern as we started the quarter and look forward to year end. As Ben will discuss shortly, a turned out financing was more available around year-end than expected, so we encouraged some opportunity costs on that longer duration funding and return for our risk management.

At December 31st, we had 1.7 billion of swaps in place with a weighted average term of 31 month, and average fixed rate pay of 3.05%. At the end of quarter three, our position was 1.4 billion of swaps with a weighted average term of 30 months and a fixed rate of 3.31%.

Briefly touching on leverage, because of the 197 million of additional capital received from the December offering, we self funded our new purchases. Since we do not incur any additional repo debt and our asset prices increased. These factors together had a quarter ending leverage of 6.1, down from 8.7 at the end of Q3.

In summary, we were methodical during the fourth quarter, where not everything when exactly as we may have wanted. We are quite pleased with the results and comfortably ended the year on a nice liquidity position. While our earnings were somewhat lower than the third quarter, our annualized ROE was still 15.5%.

As another performance to note, if you want to invest in our IPO you'll enjoy $2.60 of share appreciation and $2.80 of dividend, for total return of 22.5% in eight months or almost 34% if you're annualizing.

With that, I'll hand the call over to Ben, to discuss some of the portfolio specifics of the quarter.

Benjamin M. Hough

Thanks Ken. I would like to talk not only a little about the quarter, but also give some color on activities that we're in. Starting with the conditions in the repo market and year-end rolls '08 indeed ended with a romper, with all of the fad intervention, we avoided the chaos that many had expected. This was a welcome surprise, even though we took some aggressive steps to ensure our book will be funded if conditions worsen.

As it served us well in previous quarters, we hold repo with the least favorable terms, the shortest amount of time and extended over terms we're best. As for the quarter developed repo providers actually began reaching out to us and offering repo over year-end, while at the same time LIBOR and repo rates were consistently dropping. 30 day LIBOR fell over 300 basis points between mid-October and mid-November. So while we were looking to lock in about half of our repo book into January, we executed gradually as rates came down. There is a portion of our 30 day repo that is designated for hedge accounting which we couldn't roll until late December. So we set those repos aside to roll with those counterparties to ensure us year-ended availability.

At December 31, our short-term repo that is excluding our 500 million term repo had a weighted average rate of about 199 with 22 days until the next roll in January. Currently, we're seeing 30-60 day repo rates at around 65 to 75 basis points on average. Our total repo capacity increased over the fourth quarter from the addition of new counterparty relationships and a higher capital position after the December offering.

On the asset side, we're concentrating on the external factors that may affect price, yield and prepayments of our MBS. As Ken mentioned, our prepayment rate came in at a low 7.84% for the fourth quarter, but we do expect prepayment rates will increase some from here as mortgage rates are now 50 to 100 basis points lower than from most of last quarter.

While we are monitoring the details of new policy initiatives, we believe that there are still significant barriers to refinance for a large portion of home owners that will serve to mitigate prepayment. Its important to note that in the prepayment spike back in 2003 to '05 we were not only dealing with refi's into lower rates, but also cash out refi's housing turnover, product innovations and overall easy credit, all of which we expect to be limited in the foreseeable future.

That, along with certain characteristics that we target when we purchased ARMs, such as geographic concentration, average loaned value, levels and interest only versus fully amortizing should help offset some of that prepayment risk. However, we are keeping a watchful eye on government policy as they seek newer and more dramatic solutions to today's housing and economic crisis.

Even after the Treasury announced their intend to buy agency MBS in late November spreads on our agency ARMs widened more as we saw continued... as we saw continued delevering into year end. With such wide spreads, we've got the timing of our equity raise was that deal given the improved funding and huge net interest spread opportunities available at the time.

Shortly after we priced the offering on December 9th, the Treasury was active in the market purchasing agency MBS and along with the fed rate cut on the 16th, new investor demand surfaced and higher prices resulted. As we said before, we manage our exposure to prepayments primarily by limiting the portfolio's overall premium, and while we do think that prepayment rates may remain on the low side in this environment, we do not see value in paying $103 (ph) prices on any ARMs security regardless of coupon.

If for some reason we do get that big prepayments back, our portfolio will perform better in the long run. That said, since the deal closed on December 15th we have added approximately 846 million in hybrid ARMs with a 141 million settling in late December, 571 million settling in late January, and 134 million settling in February or March. So while, we're actively seeking to add assets now toward a higher leverage number, we will exercise patience and invest in ARMs we feel will perform best in the current environment.

Like we've said before, we look at leverage as a function of liquidity and given the political uncertainty of the moment, we believe the best course of action is to operate with higher liquidity and gradually reach the portfolio size we're working toward.

As per hedging, the steep drop in rates along with spread tightening gives us what we feel is a great opportunity to add new longer-term interest rate swaps. The secondary offering in December has already allowed us to hedge more and lock in some great book value and income protection that will help offset some of the tightening on the asset side. The swap rates is low; we can quantify the downside, while the potential upside protection is greater for a longer period of time.

Since the offering, we've already added six new interest rate swaps at a notional amount of 100 million each. We were executed prior to year end and had a start date in January and three were executed after year end and start in late March. A weighted average pay fixed rate on the 600 million new swaps is 187 and the weighted term is four and a quarter years. Combined with our existing swap positions, we will have 2 billion in swaps with the weighted average pay fix rate of 289 and a weighted term of 33 months. As always, we will continue to evaluate our liability position everyday, as we add assets and as the interest rate environment evolves.

And finally, just to give you an idea of the market since year end, we've seen some hybrid ARM prices move higher about as much as point. The negative marks on our swaps book have also improved a little, as swap rates have moved higher since they were loose in the January stand about 15 to 20 basis points above where they ended the year.

With that, I will turn back over to Michael.

Michael R. Hough

Okay. In summary, 2008 was a time that we were able to build Hatteras into the exact company that we designed back in 2007. We wanted a large portfolio, a short duration, high yield in government backed securities that we could finance cheaply, hedge right and earn on attractive ROE through the cycles.

We have that portfolio now and remarkably we are financing it at a cost cheaper and at a greater spread than we expected even that are most optimistic. We know the government wants to support the housing market in the economy we'll likely use the mortgage market as one way to help to do it. We do believe though that regardless of the direction of rates or of the direction... or of direct market participation from the Federal Treasury that there are significant barriers built into our mortgage pools that will help us maintain the strength and integrity of our portfolio throughout the process.

We are in a great position to benefit from the market uncertainty, and I am very excited about our prospects for 2009.

We now like to open the line up to any questions that you may have. Operator?

Question-and-Answer Session


(Operator Instructions). Our first question will come from Bose George from KBW. Please go ahead.

Bose George - Keefe Bruyette & Woods Inc.

Hi, good morning guys.

Michael Hough

Good morning.

Unidentified Analyst

Good morning, Bose.

Bose George - Keefe Bruyette & Woods Inc.

First question I had was just on the incremental spreads that you guys are seeing out there for the capital that you are deploying, can I get a ballpark of where that is?

William Gibbs, Jr.

Sure, Bose. We're primarily adding season paper right now. And you can use for your yield calculation about 385 to 390. And as Ben already mentioned on the repo funding for a 30 day type repo, we're looking somewhere around 70 basis points.

Bose George - Keefe Bruyette & Woods Inc.

Okay. And then in terms of the swap ratio for that... for the new swap should we assume kind of where you have been running in terms of the swap percentage?

William Gibbs, Jr.

Yeah, I think we can use about a third to a little bit higher than that. And I would look at there were two or three years swaps are. Right now two year swaps are around 150 and three year swaps about 185.

Bose George - Keefe Bruyette & Woods Inc.

Okay, great. And then just in terms of deploying the capital, I mean given the changes increase in price in the market et cetera. And what's the time frame that we could use in terms of fully deploying the capital that you guys have raised?

William Gibbs, Jr.

I don't know if I want to give you an exact date, what I am going to definitely say is, what we're going to do is be patient, we've been patient since the offering. As Ben and Michael have mentioned already, we saw our prices run on us a little bit for a number of reasons. And we are going to be patiently looking for bonds that fit our dollar price range as well as the characteristics we're looking for that we believe will perform better in slightly higher prepay markets.

Bose George - Keefe Bruyette & Woods Inc.

Okay. That makes sense. And then just lastly on prepayments, can you just give us an idea of where trends you guys are seeing in the portfolio in January?

William Gibbs, Jr.

Sure. We saw a spike in January from the number that Ken quoted about 7.8. We saw our prepayment rate go up to somewhere close to 13% which historically looks extremely low. But I guess in comparison to where we were coming from was a spike. So, to be honest with you, we were very pleased with the number we saw.

Bose George - Keefe Bruyette & Woods Inc.

Great. Thanks a lot.

William Gibbs, Jr.



Our next question will come from Mike Widner from Stifel Nicolaus. Please go ahead.

Michael Widner - Stifel Nicolaus & Co.

Good morning guys, and thanks take the questions.

Michael Hough

Hi, Mike.

Michael Widner - Stifel Nicolaus & Co.

Congratulations on a good quarter and a good year, definitely solid results in a pretty turbulent market there. Just wondering if you could elaborate a little bit on with some of the key uncertainties alright that you guys are thinking about in the market as far as government policies, and when you might feel more comfortable taking leverage up?

Michael Hough

Hey, Mike, this is Michael. I think you hit the nail on the head, it's the uncertainties. And, as we have the transition from the... to the new administration and on the points that we were hearing, and we felt like that we didn't really have a clear picture on what they were thinking. And I think its still that way kind of we are... I mean, I think the concern that we have and it seems that the market has would be for higher prepays and for government intervention into the mortgage markets somehow, however, we haven't seen that. And we do feel like that... I guess we do feel a little more comfortable right now seeing what's going on, but we're still going to be very cautious until we get a more clear picture of what's going on.

Michael Widner - Stifel Nicolaus & Co.

Just wondering, if you could comment specifically on the things that worry you most, and I guess the things that a lot of us look at out there or they mean to climb down legislation themes. More likely than others that sort of go through, and then of course there is the continuous stock that we may add officially just force mortgage rates to stay 4.5% or 4% presumably Fannie and Freddie just eat the difference on that.

I mean is it those kind of things or there are other kind of things or there are views that you guys might have on which one of those would be the most frightening or the most negative impact?

Benjamin Hough

Yeah, I guess the mortgage climb down that we are looking out right now is more... is a bankruptcy climb down that we really don't... we're not that concerned on the impact of the agency market. If they did force through an absolute lower mortgage rate, I would guess that would be the primary... that would be a driver of insignificantly higher refinancing rates.

So, I think you did hit it that those were the two that we are considering and we're looking at, you know we have a portfolio that is in a very well position to deal with prepays regardless of just the direction of interest rates or government intervention. So, we are feeling fairly confident with potential government moves.

Michael Widner - Stifel Nicolaus & Co.

Great, thanks, and I appreciate that. And then just one other one if I could, if you could just quickly comment and you did a little bit on the call about the availability in the pricing and sort of your outlook for hybrids in the current market. I know you are buying seasoned hybrids, doesn't look like there is much new flow of hybrids coming. So I was just wondering if you could comment on, whether your... what are you concern about that market, it seems like, well I'll just leave it that.

Frederick Boos II

I'll take a shot. This is Fred. Thanks for the question Mike. In the current size of the agency our market is 300 plus billion. Our estimation is on any given day dealer inventories would range from 0.5 billion to 2 billion. So I mean it is a deep market still granted as you pointed out.

The origination of hybrids ARMs has slowed (ph) in the last say month or two to right around a billion may be little about under a billion. But our view is still that it's a viable and attractive alternative to fixed rate mortgages. It offers a lot of alternatives to the average borrower in a lower mortgage rates. Its hybrid nature, its affordability; its IO characteristic on some... in some cases. So our view is that it's still going to be a vibrant market.

We have... we are vigilant to the volume and we watch that on a monthly basis and lastly I would say we're encouraged of late because we've recently seen hybrid ARM origination rates fall below 15 and 30 origination rates for the first time in several months and we think that's an encouraging sign for future production and origination volume.

Michael Widner - Stifel Nicolaus & Co.

Very well, thanks. Definitely I appreciate the color and congratulations again on a good quarter and a good year.

Frederick Boos II

Thanks Mike.


(Operator Instructions). And next question will come from Gabe Poggi from FBR. Please go ahead.

Gabe Poggi - Friedman Billings Ramsey & Co.

Hey guys, how are you doing, good morning.

Michael Hough

Okay, fine.

Gabe Poggi - Friedman Billings Ramsey & Co.

Question, in that I think that you are guys are being prudent in putting the money to work, just can you speak to I guess to kind of piggy back on the last question, the availability of secondary product and in that with the government in buying fixed rate, what has that done to overall levels of hybrids. And are you still finding pockets, I know the market's big and deep, but are there enough pockets for you guys to deploy that capital... hopefully deploy that capital over the next two or three months or whatever period it is to define the assets that you guys have historically purchased?

William Gibbs, Jr.

It is Bill. There is definitely in our view enough supply out there and supply hitting the markets through did less (ph) as well as dealer inventory for us to accomplish what we're looking to do. We are being disciplined that the main thing that we're looking at in terms of taking our time is trying to maintain that discipline in dollar price.

Gabe Poggi - Friedman Billings Ramsey & Co.

Right, exactly that was...

William Gibbs, Jr.

And when you look back to how there was a good deal of the secondary market that despite that probably went on three years as Michael mentioned earlier, but you're definitely seeing pay for this coming out in the secondary markets through bid less. It comes more in line with what we're looking for.

Gabe Poggi - Friedman Billings Ramsey & Co.

Okay, great. That's I needed. Thanks so much guys.

Michael Hough

Sure, thanks Gabe.


The next question will come from Bill Woody, a private investor. Please go ahead.

Unidentified Analyst

Good morning gentlemen.

Kenneth Steele

Hello, Bill.

Michael Hough

Good morning.

Unidentified Analyst

It was certainly being good to investors this past year, which deteriorated dramatically (ph) estimated to a net asset value will hold up in '09.

Michael Hough

No bill I don't think we're prepared to make any forward-looking estimates right now, but we do feel very good for the agency MBS market and the fact that it is trading well. And we do... we're definitely confident that interest rates are going to stay low. So we're pretty excited about 2009. We are going to look at... we are going to look this year as the yield curve has move lower to begin to add some swaps to the portfolio and to increase some hedges and lock in return. So, I think we are very positive for this year and look for the future.

Unidentified Analyst

Okay, thank you.

Michael Hough

Thank you, Bill.

Michael Hough

Okay. Well I think that's all the questions, if I am correct, operator?


That is correct, sir. There are no further questions at this time.

Michael Hough

Thank you all very much for attending the call and we look forward to talking again next quarter.


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

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