Arlington Asset's (AI) CEO Rock Tonkel on Q2 2016 Results - Earnings Call Transcript

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Arlington Asset Investment Corp. (NYSE:AI) Q2 2016 Results Earnings Conference Call July 27, 2016 9:00 AM ET


Rich Konzmann - CFO

Rock Tonkel - President and CEO

Brian Bowers - Chief Investment Officer


Douglas Harter - Credit Suisse

Jessica Ribner - FBR & Co.

Trevor Cranston - JMP Securities

David Walrod - Ladenburg

Merrill Ross - Wunderlich


Good morning. I’d like to welcome everyone to the Arlington Asset Second Quarter 2016 Earnings Call. Please be aware that each of your lines is in a listen-only mode. After the Company’s remarks, we will open the floor for questions. [Operator Instructions]

I would now like to turn the conference over to Rich Konzmann. Mr. Konzmann, you may begin.

Rich Konzmann

Thank you very much and good morning. This is Rich Konzmann, Chief Financial Officer of Arlington Asset.

Before we begin this morning’s call, I’d like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risk and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances.

These forward-looking statements are based on management’s beliefs, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the Company’s Annual Report on Form 10-K for the year-ended December 31, 2015, and other documents filed by the Company with the SEC from time-to-time, which are available from the Company and from the SEC, and you should read and understand these risks when evaluating any forward-looking statement.

I would now like to turn the call over to Rock Tonkel for his comments.

Rock Tonkel

Thank you, Rich. Good morning and welcome to the second quarter 2016 earnings call for Arlington Asset. Also with me today are Eric Billings, our Executive Chairman; and Brian Bowers, our Chief Investment Officer.

Before discussing Arlington’s results for the quarter, I would like to begin by providing a bit of commentary on the overall market, uncertainty around the global economic impact of the United Kingdom’s referendum vote, supporting its exit from the European Union in late June, created pressure on risk asset prices and a flight to the safety of U.S. Treasury’s driving the 10-year U.S. Treasury rate to historic laws with a low of 136 in the first week of July after reaching 193 basis points early in the first quarter -- excuse me, second quarter.

As confidence returned, market conditions stabilized and equity markets rallied with the Dow Jones’ industrial leverage reaching its historic high. In July, as recent economic data suggests, the U.S. economy may be more steady than previously expected, creating an environment where long-term interest rates are near historic lows while available investment spreads remain compressed across all fixed income alternatives.

Market participants’ expectations for increases in the federal funds rate during 2016 have diminished materially as compared to early this year with the yield curve flattening during the quarter as the short-end of the curve has remained relatively unchanged and the long end has declined.

In the residential MBS market, the significant decline in mortgage rates in 2016 combined with typical seasonal factors resulted in elevated prepayments fees during the quarter and market expectations of somewhat high -- continued high prepayments fees in near future, compressing asset yields. Despite these lower yields, at current spreads and current hedging costs, new dollars invested into the hedged MBS portfolio are generating attractive returns. Against the backdrop of this investment climate, we believe agency MBS portfolios like Arlington’s benefit from historically low funding rates, favorable hedging costs for extended period, attractive investments spreads relative to other alternatives provided they’re adequately hedged, as well as the prospect of potential upside and returns from lower prepayments fees and increased yields to be extent seasonal factors subside and interests rate stabilize.

In sum, we believe these factors combine in a positive way to offer an attractive long-term hedge return opportunity to shareholders and companies with agency MBS portfolios, similar to Arlington’s.

Turning to the actual results for the quarter, we reported GAAP net income of $0.56 per diluted share for the quarter. The Company’s non-GAAP core operating income was $0.67 per share, in line with our expectations and supportive of our second quarter dividend. Our core operating income declined $0.13 per share from the prior quarter, due primarily to higher prepayments fees in our agency MBS portfolio and to a lesser extent, the replacement of our remaining 10-year U.S. futures with 10-year interest rate swaps.

In response to the significant drop in rates in the first half of the year as well as the normal seasonality prepayments, the weighted average CPR for our agency MBS portfolio during the second quarter was 11.4%, compared to a CPR of 8.14% for the prior quarter. Since the Company’s agency MBS portfolio was purchased at a premium to par, faster actual prepayments can have a negative impact on the Company’s agency MBS yields, while slower actual prepayments can have a positive impact. As a result of the higher prepayments fees during the quarter, the weighted average effective asset yield on our agency MBS declined to 2.73% for the second quarter compared to 2.93% during the prior quarter. The lower effective asset yield on our agency MBS equated to approximately $0.08 per share decline in core operating income as compared to the prior quarter. Also, our core operating income includes net interest expense and interest rate swaps but does not include any economic costs of exchange traded hedged instruments, such as euro dollar treasury and interest rate swap futures.

During the first half of 2016, the Company’s replaced its remaining positions in futures with equivalent tenure [ph] interest rate swaps. Although this change in the types of interest rate hedging instruments did not materially alter our overall hedge position, the change did result in an approximate $0.03 per share decline in our core operating income during the second quarter as compared to the prior quarter from a recognition of that additional swap interest expense.

Also, as previously discussed during our first quarter earnings call and described in our investor presentation, we would like to reiterate that our core operating income for 2016 is not directly comparable to amounts reported for 2015, with respect to our net interest expense from interest rate swaps, since the Company began using interest rate swaps in place of futures in late 2015.

As of quarter end, the book value per share was $18.77 per share. Our tangible book value, defined as GAAP equity less our deferred tax asset was $13.92 per share as of June 30th, a $0.53 per share decline from the prior quarter. The contributing factor to the decline in tangible book value were a modest decline in the value of our hedged agency MBS portfolio, non-recurring proxy related costs -- proxy contest related costs and a slight decline in the value of our private label MBS portfolio.

During the second quarter, the net value of the Company’s hedged agency portfolio declined by $0.25 per share or 1.7% of the prior period tangible book value, relative to a volatile rate environment that saw the 10-year U.S. Treasury rate reach historic lows leading to further MBS spread widening during the quarter. As we discussed in last quarter’s earnings call, the Company modified its hedge position at the beginning of the year by reducing its 10-year U.S. Treasury note future position and purchasing put options on 10-year U.S. Treasury note futures. The put options on the 10-year U.S. Treasury note futures provide the Company with protection against the significant rise in interest rates while also reducing future book value volatility in the falling interest rate environment. With the interest rate rally in the second quarter, this change in our overall interest rate hedge position helps to limit the decline in the Company’s book value this quarter.

The Company continues to maintain a substantial hedge position with the intent to protect the Company’s capital and earnings potential against increased rates over the long-term. Our hedging strategy enables the Company to maintain an attractive return on its agency portfolio in order to produce resilience and predictable core operating income that supports consistent dividends to our shareholders.

In a falling interest rate and wider spread environment, such as this past quarter, this hedging strategy will likely result in a temporary decline in book value. However, the Company would expect that this temporary decline in book value would be recovered over time, either through higher future spread earnings, if interest rates remain low and spreads wide, or through a reversal of this temporary decline in book value, if future interest rates rise and spreads narrow. The consistent execution of our hedging strategy may also result in an increase in leverage during periods of temporary declines in book value or decreases in leverage -- during periods of temporary increases in book value.

As of quarter-end, the Company’s agency investment portfolio totaled $4.5 billion, consisting of $3.6 billion of specified agency MBS, $107 million in commitments to purchase specified agency MBS, and $805 million of net long TBA agency securities. The Company’s specified agency MBS continues to be invested in 30-year fixed rate securities of specified pools with characteristics selected for prepayment protection. During the second quarter, the Company’s specified agency portfolio performed well as pay-up premiums on our aspect [ph] agency MBS portfolio increased almost 0.5 point during the quarter.

At quarter-end, the Company had approximately 86% of investable capital dedicated to its hedged agency MBS portfolio and 14% allocated to its private label MBS portfolio. At quarter-end, the private label MBS portfolio had a fair value of 73.8% of face value, total market value of $89 million and outstanding repo financing of $30 million. During the second quarter, the Company sold private label MBS for sale proceeds of $38 million.

Total net realized and unrealized investment losses on private label MBS during the quarter were $2.9 million that contributed $0.12 per share towards the decline in book value. Subsequent to quarter-end, the Company sold an additional private label MBS for sale proceeds of $21 million. The Company reinvested the capital from the sale of these private label securities during the quarter and third quarter in the hedged agency MBS with higher levered returns. The Company continues to utilize its tax benefits afforded to it as a C-corporation that allow it to shield substantially all of its income from taxes.

As of quarter-end, the Company had estimated net operating loss carryforwards of $98 million and net capital loss carryforwards totaling $291 million. From a book accounting perspective, the Company had a deferred tax asset of $112 million or $4.85 per share. The Company continues to record a substantial valuation allowance against a portion of its deferred tax asset attributable to the net capital loss carryforwards for which the Company is uncertain it will be able to utilize prior to their expiration.

During the second quarter, the Company recorded a decrease of $11 million to its valuation allowance against its deferred tax asset, attributable mostly to net gains on its agency MBS portfolio.

At the Company’s June annual meeting, Arlington shareholders overwhelmingly voted to re-elect the Company’s existing directors, rejecting the Imation Group’s attempt to take control of the Board and the Company. On behalf of our Board of Directors and management team, I’d like to say that we listen to and we appreciate, the feedback we receive from holders, and we thank our fellow shareholders for their support of our efforts to continue to drive strong returns and value-creation over the long term.

During the second quarter, the Company absorbed $3.6 million in non-recurring expenses related to the 2016 proxy contest that are in excess of those normally incurred for an annual meeting of shareholders, which contributed to a 16% decline per share in the Company’s book value during the quarter.

Overall, the focuses of our agency, investment and hedging strategy is to main the approximate scale and attractive return characteristics of our portfolio, in order to create the highest present value opportunity for shareholders, and to deliver consistent dividends over time.

During the second quarter, the Company generated a positive economic return, provided 18.9% annualized return on tangible book value from non-GAAP core operating income and declared a dividend of $0.625 per share, continuing the Company’s consistent track record of delivering a robust dividend to shareholders over the last 26 quarters for a total of $20.03 per share. The Company remains committed to delivering consistent dividends and attractive long-term returns for our shareholders.

And I would now like to turn the call over for question please.

Question-and-Answer Session


At this time, we will open the floor for questions. [Operator Instruction] And the first question will come from Douglas Harter with Credit Suisse. Please go ahead.

Douglas Harter

Rock, you mentioned a little bit about some of the hedging changes you made. Would you attribute that to the significantly smaller change in book value this quarter compared to the first quarter?

Rock Tonkel

Yes. I think the inclusion of options and in replacement of a portion of the 10-year futures or swaps position of the hedges has given the Company, as we have talked about before, more flexibility to respond to a rate rally and yet retain the protection against the meaningful rise in rates on the upside. So, I would say, yes. In fact, that’s a major contributor to the lower sensitivity to rates during the quarter, which effectively in agency portfolio was about 1%, 1.5% real economic change during the quarter in the agency portfolio, from a book value perspective.

Douglas Harter

Great and then, kind of as you look out at the landscape, is there anything else from an investments standpoint that you guys are looking at in addition to agencies, or should we expect sort of all incremental capital to go to agencies at this point?

Rock Tonkel

Well, as we stated and I think as we all observe that investments spreads generally particularly in liquid fixed income classes are generally pretty tight, particularly those that we observe most closely in the residential space. I think, we view the non-agency portfolio -- non-agency opportunities like the ones we own and some of the others within the residential non-agency class to be attractive. It’s not that they are not attractive, it is that they can’t compete with the alternative returns available on agency without levering them more meaningfully than we are comfortable doing, I don’t think we have talked about that before, and exposing the Company potentially to the mark-to-market risk therein, against the financing on those assets. And so, the available relative return on the agency side, given that you can hedge that position today with the combination of elements that allows you to fund it somewhere around 1% between your repo cash cost of funding and your longer term hedge instruments against an asset that’s yielding closer to 3%. And that offers a pretty compelling alternative that when one applies the leverage levels that we’re comfortable with and I think consistent with what we talked about over time that that produces a high-teens, at least the high-teens return on that agency investment alternative that surpasses the other residential non-agency alternatives that we think are appealing, but can’t quite compete on a return basis.


Thank you for your questions. The next question will come from Jessica Ribner with FBR & Co. Please go ahead.

Jessica Ribner

I’ve got a couple of questions for you. The first is just as it relates to the buyback, what are you thinking about that in the next couple of quarters?

Rock Tonkel

Well, I think we think about it looking forward as we’ve talked about it a little bit in the past, which is that we view it opportunistically. We have been buyers of the stock when it is a sufficiently compelling and accretive exercise for the Company, which in those environments is certainly the first thing we look to. But, I think in this environment at these prices that capital is better utilized on behalf of the shareholders over for the long-term return to be retained in the business at this point. I think we’re always open to it. We always look at it constantly. As we’ve said and as you’ve observed in the past, we have bought stock at really highly accretive levels, and we’ll continue to do that in the future. We have the authorization. It’s an exercise we go -- we are constantly evaluating. And so that’s how we think about it.

Jessica Ribner

And then, just in terms of the cost of finance, there’s been a lot of talk around repo obviously, given all the capital, standards, the things you’re facing. And I noticed that your cost of funds ticked up quarter-over-quarter. How can we think about that over the next two to three quarters? Do you expect cost of finance moderately rising [multiple speakers].

Rock Tonkel

First issue is what does the Fed do, right, because the short-term Fed funds rate will drive -- will certainly have an impact on what the repo financing is, and presumably out the curve as well, as expectations shift, if the Fed were to move. So, setting that aside, which is obviously the -- by far the most significant factor. But setting that aside, the other factors are really more nuances and probably mostly reflect moderate changes in funding markets, but also for us specifically simply reflect the adjustments from the FHLB. For a short period of time, we had a block of financing that was financed at lower rates than market rates with the FHLB. And when the captive insurance entities were excluded from access to the FHLB advance window, then those balances rolled off. And at the margin, you’ve seen some modest increase in incremental funding cost from there. I wouldn’t call it really meaningful. Any other changes would simply be movements in month-to-month or quarter-to-quarter changes in market funding rates, which haven’t moved that much but have recently tended to be between below 60 basis points and below 70s.


Thank you for your question. The next question will come from Trevor Cranston with JMP Securities.

Trevor Cranston

First question, in the prepared comments, you talked a little bit about the higher CPR levels for the second quarter and the impact on earnings. Can you talk about your outlook for the third quarter on CPRs and whether or not that would impact how you’re potentially thinking about the dividend going forward?

Rock Tonkel

Good question, Trevor. I think part of it depends on rates; we’ve had a rate volatility over the course of the last year or two and specifically the last years. So that obviously has a meaningful factor, which is unpredictable. I think in the normal seasonal effect, we might tend to see it start to tail off, either now or sort of as the summer ends, we start to see those tail off a bit, turn back toward levels that we may have seen late last year, early this year, which would have been more like in the high single digits.

So, if seasonal factors follow historical patterns over the last couple of years, that’s what we would expect to see but that’s all provided, rates don’t really move much or don’t move down much. Obviously, if they move up, then you’d expect to see those speeds flow, and get the benefit of that. Our expectation probably going forward at the margin is that we would expect to see them shallow out a little bit in the next quarter and maybe a little bit more after that, but that is dependent on no incremental drop in rates. And so, if you think about the earnings rate that we demonstrated -- that the Company demonstrated in the second quarter, what are the factors that might affect that in the third quarter, certainly one would be if the Fed does anything; number two -- from a funding cost perspective naturally and otherwise; number two would be the question you are getting at which is the speed differential if there is any stable -- any reduction in speed or whether they sit here or move up, that would have an impact on us. And I think at the margin, the other thing that might have an impact on portfolio would be that the redeployment of the incremental proceeds from the sales of non-agencies that have occurred thus far in the third quarter that we alluded to and potentially if risk markets permit additional sales in the third quarter, then you might see some additional redeployment of that to incremental balances of agencies, which could provide a boost to the margin, to earning assets and therefore spread earnings.

Trevor Cranston

And on leverage, obviously the leverage number went up quarter-over-quarter on tangible capital. Can you talk about generally, how much room you think to continue increasing leverage as you redeploy capital into the agency strategy?

Rock Tonkel

Well, the leverage is a product of really principally a couple of things. It’s a function of what proceeds we may redeploy from non-agency, which generally are going to be levered at 0.3 or 0.4, something like that; how much of those proceeds in a given period of time are reallocated over to the agency side, which generally when we are investing in that we are going in it somewhere in the neighborhood of 8 times, which I think is a number you have heard from us before on the entry leverage point somewhere in approximately 8 times new capital investment into the agency side, and the second factor obviously is what the temporary movements maybe in book value, whether that’s down from a rate rally scenario or up from a rate movement and spread compression scenario. And that will be the other factor affecting leverage. I think as I just alluded to, I think you will see some incremental movement of capital to the agency side from the non-agency side, so at margin -- that will be a marginal contributor to a modest increase in leverage and how markets treat spreads out. What rates do and what’s spreads do in the quarter, we will see, and that will have some impact on leverage at the margin as well.


Thank you for your questions. The next question will come from David Walrod with Ladenburg. Please go ahead.

David Walrod

First, I wanted to talk about on the repo side, anything you’re seeing in regards to availability of repo, just from your providers, given all that’s going on kind of around the world?

Rock Tonkel

We haven’t really seen anything significant new to report there, Dave. I think on prior calls, we have noted that initially a couple of years ago, few years back, the European banks started to back out -- back away a bit from the repo funding market; that’s been two years on the rear view mirror probably. The U.S. banks another middle market participants and some of the other international banks took those positions up easily, I think for us and for others. In the market, I think that’s still generally true. One or two of the U.S. banks over the last year, and I think we have talked about this, maybe slowed their growth in that market a little bit. But generally, I don’t think we have anything relevant to report from what we are seeing in incremental developments on the funding side over the last several months.

Brian Bowers

Dave, this is Brian. I would tend to agree with Rock. Actually the landscape is quite competitive and we are seeing quite a good availability across all the different counterparties. So, they have appetite and they are looking to grow would be the thing to say here

David Walrod

Okay, great. That’s good to hear. In regards to your core economic earnings, is there any residual impact, when you look to $0.67 for many of the futures positions or can we think of $0.67 as a good core run rate?

Rock Tonkel

I think that’s a good question, Dave. I think there is probably a little bit more pick up there to go, but it’s very minor, maybe a penny or a couple of penny, something like that.

David Walrod

Okay, great. And then, my last question, Rock, is you talked a little bit about the NOL in the end of your prepared remarks. Can you just expand on that a little bit as far as when those expire, and just kind of give us little more detail on that?

Rich Konzmann

Sure Dave, this is Rich. The NOLs have quite a long time for to expire; I forget the exact…

Rock Tonkel


Rich Konzmann

Yes, 27. So, we have plenty of time to utilize our NOLs before they expire. Right now, as we reported, we have about $99 million at the end of June 30th in NOL carryforwards and really at our run rate right now. We’re pretty comfortable that we could have, in addition to this year, up to maybe two more years at the C-corp, really at the end of 2018 will kind of be the inflection point to see when we kind of break out -- when we hit those. And I would say, if we use them earlier than expected, that’s a good thing anyway, because we were generating more income, a good problem to have. But that’s kind of really right now where we think the inflection point is.

Rock Tonkel

I think the combination, Dave, of the recognition of the swap expense is -- that’s extending the life of the NOLs at the margin. I also think that we have been working hard to identify ways to be tax efficient; incrementally, we’re always doing that. And I think there has been some improvement there as well beyond just the improvement in our NOL position, our longer term NOL sustainability from the use of the swaps. And so, I think the news there is that at the margin, the window for ongoing usage of the NOLs, availability of the NOLs and therefore the C-corp construct is extending in time and we’ve probably already seen it extend by a year. And there may be more available to us in that way going forward.


Thank you for your question. [Operator Instructions]. The next question will come from Merrill Ross with Wunderlich. Please go ahead.

Merrill Ross

I am wondering especially about the two-year swaps, the 750 notional amount, whether there is any room to terminate those swaps in light of the outlook. I mean, John Williams [ph] specifically said that the fed would be able to raise rates one more time and then not again until 2019. So, two-year swap seem to be a little outside the envelope of that. If you believe what he says, so, I am just wondering if there is any room to maybe hedge little more efficiently and call back a little margin.

Rock Tonkel

It’s a great question, Merrill. I think it’s -- as you would expect, it’s a question that we wrestle with all the time. And I think it does provide -- there is a potential opportunity there. I mean, you know our focus on making sure that we are well-hedged and substantially hedged against the up-rate and up-funding cost environment that could ensue as the economy -- if and as the economy continues to strengthen and that’s just policy position. So, we think about that a lot. But there is an opportunity at the margin for some incremental swap cost savings there. Those swaps cost us about 100 basis points or so gross, 100 basis points and 110 basis points gross. And repo today is about 65ish. So, there is some room there for potential pick up, if we were to view those as no longer necessary useful. But, I wouldn’t say we’re there yet. We’re not there right now. It’s something we evaluate and it’s definitely a possibility for improvement down the road.


Thank you for your question. There are no further questions at this time. Mr. Tonkel, I’ll turn it back to you.

Rock Tonkel

Great. We appreciate your time. And if you have any further questions or observations, please you know where to reach us. Thank you very much.


Thank you, ladies and gentlemen. This concludes today’s teleconference. You may now disconnect your lines.

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