Capstead Mortgage Management Discusses Q3 2013 Results - Earnings Call Transcript

| About: Capstead Mortgage (CMO)
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Capstead Mortgage (NYSE:CMO) Q3 2013 Earnings Call October 24, 2013 9:00 AM ET


Lindsey Crabbe

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

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

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


Steven C. Delaney - JMP Securities LLC, Research Division


Good morning, and welcome to the Capstead Mortgage Third Quarter 2013 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Lindsey Crabbe. Please go ahead.

Lindsey Crabbe

Good morning. Thank you for attending Capstead's Third Quarter 2013 Earnings Conference Call. The third quarter 2013 earnings press release was issued yesterday, October 23. The press release is posted on our website, at, under the Investor Relations tab. The link to this webcast is also in the Investor Relations sections of our website and an archive of the webcast will be available for 60 days. A replay of this call will be available through December 24. Details of this replay are included in yesterday's release.

With me today are Andy Jacobs, President and Chief Executive Officer; Phil Reinsch, Executive Vice President and Chief Financial Officer; and Robert Spears, Executive Vice President and Director of Residential Mortgage Investments.

Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website.

The information contained in this call is current only as of the date of this call, October 24, 2013. The company assumes no obligation to update any statements, including any forward-looking statements made during this call.

With that, I'll turn the call over to Andy.

Andrew F. Jacobs

Good morning. Welcome to our earnings call. As usual, Robert and Phil will be here for questions afterwards. But anyway, so for the third quarter was an interesting -- a very interesting time for a lot of us in the mortgage market. I mean, the 10-year Treasury was headed up towards 3%, in anticipation of the commencement of tapering. And then to the surprise of all of us, the Fed did not and now the 10-year Treasury's back down at or slightly below 2.5%. But keep in mind that's still substantially higher than the lows we saw back in March -- excuse me, in May, which were in the-- down towards 160 basis points.

So all in all, what we've seen is a -- with higher mortgage rates, mortgage refinancing activity as a whole has dropped significantly. And I think a lot of the headlines you've been hear, almost every other day or so, is that a lot of mortgage originators and banks have reduced their origination staff significantly, which should provide some still further constraint on origination capacity, even if rates were to stay at this level. So we feel there's a good refinancing story from the standpoint of being able to free [ph] flow or prepay on a go-forward basis.

During the quarter, the higher rates and everything -- you had lower prepayment rates for the mortgage securities as a whole but on prepayment actually lag -- lots of lag. With the prepayment levels, declines have been relative to fixed rate. We actually saw -- during the quarter, we saw our average prepayment rates move up to 25.5% CPR in the third quarter compared to 23% last quarter. And that increase actually, quarter-over-quarter, was about $5.4 million increase in premium amortization for a total amortization of $39 million of our investment premiums. That was a big number. It had the impact, obviously our net interest margins were lower by about $4 million. The yields on our assets -- so our net interest rate declined to 0.87%, down 13 basis points but our -- the yield on our assets declined about 17 basis points, of which 15 basis points was the additional premium amortization.

Repo rates, we did get a little bit of benefit. They were down by about 4 basis points but really the story is that, with a higher prepay, the additional $5.4 million in amortization, that costed us a lot of money. And it really impacted what our net interest margin and yields on our assets were this quarter. I think we have a very good story as to where it's going from here.

Portfolio-wise, we bought about $1 billion in short-duration ARM security, which largely replace run off. I think it's very important to note that we have not sold any assets during 2013.

Overall, our leverage ticked up a little bit. We're at 8.68:1 and our net duration gap is 1 3/4 months. I think as you see in the press release our book value declined $0.45 to $12.35. This is a result of, 1, slight pricing declines relative to the ARMs security but also portfolio runoff and hedge instrument run off during the period, as well as also paying a dividend in excess of earnings.

Just a final couple of remarks regarding prepayments. If you go back on a month-by-month basis, during the third quarter both July and August, the CPRs were -- as I said, overall everything was higher. The CPRs in July and August were over 26%. They declined in September to 23%. And then, as we reported, in the month of October we saw them decline to 17%. And I think if you look at the 17% compared to what the average for the third quarter was, I think what you're going -- which was 25.5%, what you're going to -- what you see is that there's a 33% reduction in what our CPRs were, as well as it's not unreasonable -- we don't know November and December prepayments at this point but everything we can see here, looking at indexes and various things, is that we don't think it's going to be materially different than what we saw for October. And if this proves to be correct, a 33% reduction in amortization, when we amortize $39 million for the third quarter, a third reduction in that would be pretty nice. So you'll see -- I think you'll see, very likely, a very substantial pickup in net interest margins, then amortization, probably about 35 to 40 basis points pickup just purely with fuller amortization.

So I think that's the story I think everybody needs to keep in mind. And that's clearly where we're -- in looking at our dividends and setting our dividends, our portfolio is different than most people in our industry. In looking at where we're setting the dividend level and stuff, we're looking at where we think we're going to be on a go-forward basis and part of paying $0.23 -- but part of paying $0.31 when earning $0.23 is we didn't see at this point the relevance of reducing it significantly and then painting in the stock. People looking at us and saying, "They're no different than anybody else." We want to make clear that we are very different in the portfolio and how our portfolio operates and you can see the pickup that we're now going to see going into the fourth quarter, I think pretty clearly.

And with that, I'll open up for questions.

Question-and-Answer Session


[Operator Instructions] First question comes from Steve Delaney, JMP (sic) [JPM] Securities.

Steven C. Delaney - JMP Securities LLC, Research Division

Andy, when we had the second quarter call, I think the color you gave on speed was that there wasn't any improvement in July but you guys I think expected as the third quarter went on that, with the rise in rates we saw in May and June, that we'd see some steady decrease, which is why I think consensus numbers were up over $0.30 for the quarter. And boy, 2 CPR makes a huge difference, as you explained to us, and hopefully a 7% to 8% drop in CPR will follow through in the fourth quarter. I just wondered if you could, rather than just maybe discussing the 25.5% in its entirety, can you give us any color within the portfolio? Was the current reset bucket, was that more volatile than the longer reset? Just any color you could give to kind of help us understand why you were surprised and why we were, as well, on the performance in some of these specific ARM pools?

Robert R. Spears

Yes, Steve, I'll take that. Basically what happened, we had a 2-month spike and the bulk of the increase was due to 2 components. Our longer [ph] reset bucket. Securities had around a 3% coupon. They spiked up to about 35% CPR and I think the reasons for that were twofold. First, fixed rates went up, a lot obviously, earlier in the year and so you had a lot of ARM-to-fixed refinancing. As fixed rates went up, mortgage originators held their ARM rates down lower for a couple of months, through late June. And so I think you had the last-gasp effort by originators and people to close their loans before ARM rates went up, as well. So that bucket increased, and also, for the first time we saw a sharp jump in our Ginnie ARM speed. Our Ginnie ARM longer to reset bucket and that was primarily driven by one originator that pretty much adversely selected his entire book and like 2.5%, 3/1 Ginnies spiked to 60, 80 CPR for 2 months and they're back down to 17 now. Basically, this guy steered people into 1.5 securities that are kind of orphaned bonds now. He basically shorted those securities, loaded up the Street to the tune of about 1.5 billion and so we saw a 2-month spike in our Ginnie speed. So in aggregate, those kinds of buckets like that kicked up the 35. Our real season short resets have been hanging in around kind of the 15, 16 area. If you look at where we think we're going to be on a go-forward basis, that longer reset bucket that kicked up to 35 is now down to 20 CPR and our season short resets are kind of down in the low teens. So that's kind of what happened. We had a 2-month spike in those coupons that were 3-ish and then the Ginnie ARMs, and it's completely subsided since then.

Unknown Executive

So we haven't count a 2-month delay of what we were truly expecting to come into play.

Steven C. Delaney - JMP Securities LLC, Research Division

Got it. That's very helpful color and I appreciate it, Robert. And almost -- it almost sounds -- we always think about refinance, we think about consumer behavior but in some ways this was sort of like lender. Lender behavior, in some ways, affected some of your specific bucket securities, it sounds like?

Robert R. Spears

Well, that particular originator just announced that they were closing and so we shouldn't see that going forward. But anyway, it's a very -- we've never seen anything like that on our Ginnie ARM's. And usually, when you saw those kind of spikes, they were spread out over 6 months and the securities would kick up to, say, 35 for 6 months. But because of the volatility in the rates market and the fact that yields went up so quickly, it was a real short-term phenomenon.

Andrew F. Jacobs

And Steve, let me add one thing. Relative to prepayment expectations into 2014, I think that -- nobody really knows how to gauge this but one of the new things, the new regulatory in the QM, the qualified mortgage regulations from Dodd-Frank actually kick in, in early January and I think that's going to make it more difficult for originators. They got to dot more I's and cross more T's because if they screw up they're going to get in a lot of difficulty, a lot of trouble. So I think that you're going -- you had all these lay-offs with the originators on one hand and now they're getting their feet held to the fire about originating perfect loans from a documentation standpoint. And I think that's going to -- that's going to increase the need for additional bodies versus what we've been doing to clients. So I think there will be some headwinds, to some extent, in early 2014, trying to incorporate the new Dodd-Frank regulations into this.

Steven C. Delaney - JMP Securities LLC, Research Division

Okay, appreciate that. And just one quick follow-up and I'll drop off. You originally -- you referred to second quarter CPR in this release as 23.1%. And when you originally reported it last quarter it was 22.7%. Just curious if there was some technical change in the way you're actually calculating CPR now?

Phillip A. Reinsch

Yes, we found a glitch in our compilation of CPR. So we corrected those previous reported CPR numbers. It moved them up about 20, 30 basis points.


Next question comes from Charles Dwayne [ph] from Wells Fargo.

Unknown Analyst

The timing of the $1 billion and short-duration ARM purchases over the course of the quarter and -- as well as the progression of yields throughout the quarter and maybe what you were seeing towards the end?

Unknown Executive

Yes. Yes, sure. The $1 billion that we purchased in the third quarter were at very attractive levels. Those types of spreads aren't available right now. Just to kind of give you a framework of what happened with mortgage spreads, from the tight in May to the wides in July to where we are now, we've retraced about half of that widening move. So those securities that we purchased in the third quarter we couldn't buy those at the same prices now. Generically, that type of security is up about 1.25 points in price. And so if you look at it on spreads, in May, we were -- most mortgage paper was trading at a spread of kind of 100 to 125. We gapped out in July, where you could buy paper with a spread of 175 to 185. Now we're back down to about -- purchases now about 150 basis points. So if you think about that on an ROE basis, assuming 8x to 8.5x leverage, we went from a kind of 10% to 12-ish percent environment, all the way up to an 18% and now we're back to about a 15% ROE on new purchases.


[Operator Instructions] This concludes the question-and-answer session. I would like to turn the conference back over for closing remarks.

Lindsey Crabbe

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

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