Hatteras Financial Corp. Q2 2008 Earnings Call Transcript

| About: Hatteras Financial (HTS)

Hatteras Financial Corp. (NYSE:HTS)

Q2 2008 Earnings Call

July 30, 2008 11:00 am ET


Mark Collinson – CCG Investor Relations

Michael Hough – Chairman, Chief Executive Officer

Benjamin Hough – President, Chief Operating Officer

Kenneth Steele – Chief Financial Officer, Secretary and Treasurer

Frederick Boos – Co-Chief Investment Officer, Executive Vice President

William Gibbs – Co-Chief Investment Officer, Executive Vice President


Bose George – Keefe, Bruyette & Woods

Steven Delaney – JMP Securities

Michael Widner – Stifel Nicolaus & Co.


Welcome to the Hatteras Financial Corporation second quarter 2008 earnings conference call. (Operator instructions) Now I would like to turn the conference over to Mark Collinson from CCG.

Mark Collinson

Welcome to the Hatteras second quarter earnings conference call. With me today are the company’s Chairman and Chief Executive Officer, Michael Hough; President and Chief Operating Officer, Ben Hough; Chief Financial Officer, Kenneth Steele and Co-Chief Investment Officer’s 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 the 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 rate spreads, the yield curve or prepayment rate, changes in economic conditions generally, inflation or deflation, availability of suitable investment opportunities, terms of deployment of capital, degree and nature of the company’s competition, general volatility of the capital markets dependent 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 recent initial public offering filed with the Securities and Exchange Commission.

The content of this conference call contains time sensitive information that is accurate only as of today, July 30, 2008. The company undertakes no obligation to make any revisions to the statements contained in its remarks or to update to reflect the events or circumstances occurring after this call.

With that it is my pleasure to turn the call over to Michael Hough.

Michael Hough

Welcome everyone to our first quarterly conference call as a public company. I have with me today the entire Hatteras management team and following a brief, prepared introduction and summary we are all available to answer any questions you have regarding our second quarter results and the current operating environment.

We’d like to use this occasion today to introduce some key points of our strategy in addition to a discussion of the quarter. This is the third quarter in which Hatteras has been in business but as of today we have been a public company for just three months. Since our beginning in November the financial market environment has obviously been remarkably volatile which has really been the impetus for this opportunity and for our success at building this balance sheet at an opportune time of favorable rates and spreads.

Hatteras is now listed under HTS on the New York Stock Exchange. This November we completed three successful capital raises. First, the 144A priced at $20. The second a 144A priced at $24 and the IPO priced at $24. The second two raises were both accretive to book value. We have sold a total of 26.78 million common shares and grew stock owners equity to approximately $572 million at what we see was the opportune time.

So getting to scale quickly was important for us because one our expenses significantly declined as we grow for our scaled down fee structure and two for the obvious benefit shareholder’s get from the increased market flow for our shares.

Since the IPO closed on April 30 we have consistently invested into very attractive, agency-backed securities and now we are ending the quarter with a fully invested portfolio. During the second quarter we methodically invested the proceeds of Fannie Mae and Freddie Mac guaranteed securities according to our plan and have ended up with a portfolio yield and net interest spread almost exactly where we projected it would be during the road show. We are executing a very focused strategy here that we believe positions our company in the best way possible for the long-term.

In June we announced our first quarterly dividend as a public company of $0.75 per share. The dividend was paid on July 25 to shareholders of record on June 30. Keep in mind that while a $0.75 quarterly dividend equates to a very attractive annual 12.5% yield to the IPO price of $24, we are in a great operating environment and it doesn’t completely reflect the fully implemented balance sheet and the spread we now have in place.

The third quarter will be the first opportunity for us to realize a full run rate of earnings and you can refer to the earnings release for additional portfolio information.

While the markets were choppy during the quarter especially on the credit side we were able to more than sufficiently increase our repo book to finance the acquisition of more than $2 billion of new assets. Funding the portfolio really has been uninterrupted since our inception with the only real change coming from the well-documented increase in haircuts from 3-5% in March.

However, agency repo lenders have definitely taken a more conservative view of lending since the credit crisis started last August so a primary goal of ours is to continue to increase the number of our counter-partner relationships. We now have 18 in place and have outstanding repo with 13 of them as of today. We are transparent in our dealings with them and view excess repo capacity as a vital part of this strategy.

For those new to the Hatteras story I’d like to note that this has been an endeavor of opportunity and timing since day one. Although Hatteras is still quite young our team together has been exclusively running a privately held, agency only MBS breed through multiple cycles since we founded it almost 10 years ago. Given this yield curve opportunity and the opportunity to capitalize on historically wide spreads we elected to take our experience and with a clean slate form Hatteras. We started this company in September 2007 because we perceived a tremendous opportunity to exploit an improving interest rate outlook, a steepening yield curve and a credit market dislocation at the same time. This was our opportunity to create from scratch a new portfolio of unusually high yielding GSE backed securities funded with new, low cost liabilities to be structured into the asset liability mix we desired.

We are very pleased with how the company looks now and we feel we are in a great position going forward. I’d also like to spend a minute or two on our investment philosophy before handing the call over. Our expertise through each of our 20+ year careers are as interest rate risk managers and not credit risk managers. In our 10 years of doing this exact strategy we have never invested in a non-agency guaranteed asset because of the confidence we have that the agency security market will remain intact and fundable through times of crisis. It is from this experience that we are comfortable now more than ever that we have mitigated credit risk in our strategy by utilizing Fannie Mae and Freddie Mac securities and we fully expect that their credit quality will continue to demand favorable terms in the repo market and enable us to effectively manage our strategy.

We invest only in GSE backed securities. We focus specifically onto the hybrid ARM part of the yield curve, principally because it affords us less duration risk, more predictability than the other options we have in investment. Using a realistic range of prepayment expectations and our low premium price targets, we expect hybrids will have the most predictable and manageable shifts in duration to us in up and down interest rate environments. This greater predictability has two primary benefits; first it makes modeling and forecasting we do more reliable and therefore more helpful and second it improves the effectiveness of our hedging strategy by enabling a more consistent and accurate measure of our asset duration to which we can better hedge.

We take a long-term view of hedging our portfolios. Because we started Hatteras as a clean slate we have had the unique opportunity to build and position both sides of our balance sheet exactly how we see fit for the long-term. In today’s market environment we look at hedging as a process. We have established a base of price and income hedges for term insurance and we will continue to build upon to achieve the duration ranges we deem warranted at different times in the cycle to effectively achieve our long-term goals. Our goal is to build a dynamic balance sheet that will serve to generate a consistent return through an entire cycle, not just part of one. Then we’ll point out we will continue to appropriately layer in more liability extensions as we go forth.

So with all that said I want to thank you for your interest in Hatteras Financial. We try to provide you with as much information as we can to help you understand your investment. We believe detail is important for your analysis and we will always try to give it to you when possible.

I would now like to hand this over to Ben Hough, our President, who will give you some color on implementing our strategy during the quarter and more recently.

Benjamin Hough

I’d like to give you a fly over of our investment activities since the IPO. This market continues to provide exceptional challenges along with exceptional opportunities. Given the wide swings in the rate markets and counter-party uncertainty, Bill and Fred have done an excellent job successfully investing and financing the proceeds just as we projected.

Our predetermined investment timeline allowed us to seize attractive opportunities during the quarter because we had the dry powder to invest. From April 30 to the end of the quarter, two year swap rates moved higher by as much as 85 basis points at one point while MDS spreads moved higher by about 30 basis points on June 30 from their loans in the first week of May. We took advantage of this volatility by purchasing assets on upturns and yields and extending liability on downturns. Throughout all of this we successfully deployed the IPO proceeds as planned.

Of the total $2.2 billion of agency ARMs we added since April 30, $696 million settled on or about May 22, $1.2 billion settled on or about June 24 and about $320 million settled on July 22. Of the new purchases 7% were new or seasoned 3/1, 66% 5/1 and 27% 7/1.

The total average coupon was 519 with an average dollar price of [101.21]. Our June 320 leverage ratio was 7.8 to 1 and after financing the bonds that started on July 2 our debt to equity ratio was 8.3 to 1 based on June 30th equity. The fully invested portfolio now has 7% with 0-36 month to initial reset, 63% with 37-60 months reset and 30% at 61-84 months to reset excluding any effect from prepayment.

The weighted-average month to reset for the complete portfolio, again excluding any effect from prepayment, is currently 60 months. 72% are Fannie Mae and 22% are Freddie Mac.

We target 3/1, 5/1 and 7/1 and concentrate on 5/1 as we feel from a risk and asset liability management perspective that this is the optimal place on the yield curve to be. Our rate of principle paid out was 12% for the quarter which was influenced a lot by the low first month pay down rate on the new securities we are putting on. We are projecting a 15-17% pay down rate for the third quarter for the whole portfolio which equates to CPOR of about 13/15.

At June 30th we had $1.4 billion in extended liability. $1 billion of that was an interest rate blocks with an average rate of 3.28 and an average term of 32 months and $400 million of it was in extended repos at an average rate of 3.14 and an estimated average term of 24 months. Our combined extended liabilities at quarter end at an average rate of 3.24 and an average term of 30 months. As Michael said we approach hedging as an ongoing process and we have remained on our intended track throughout the entire course of this growth phase. We will continue to extend our liabilities as we determine needed and since June 30th we have added another $100 million of extended repos and another $200 million of interest rate swaps. Our total extended liability position today is $1.7 billion which is approximately 36% of our total liability and 34% of our mortgage backed securities.

The average interest rate on our combined extended repo and interest rate swap position is now 3.27 with an estimated average remaining term of 30 months. Since June 30th the agency spread widened even more in sympathy with the market on these regarding Fannie Mae and Freddie Mac and the potential implications of action or inactions by the government to support them. The mortgage curve has really flattened because of this and we are expecting a supply of new origination hybrid ARMs to be very low for at least the next quarter which can serve to support pricing.

On that note I’d like to turn it over to Ken for some detailed look at our financial results.

Kenneth Steele

Without rehashing our entire release I’d like to quickly point out a few items I think are important to focus on especially since this was a transition quarter and most of our numbers materially changed over the last quarter because of the addition of $256 million of new capital and $2.2 billion of new securities. I’m going to touch on a few of the portfolio metrics which are also listed in Table 3 on the back of this earnings release.

We began the quarter with 15,277,000 shares and added 11,500,000 shares at the IPO for a total number of shares outstanding on June 30, 2008 of 26,777,000. Given the significant changes in equity during each quarter since our inception we use daily share counts for computing our weighted average share for earnings per share calculations. Also for all of our other average weighted calculations we use daily balances as well as the less precise calculation will give results that were not very meaningful.

During the quarter we had average MBS of $3.38 billion and ended the quarter at $5.1 billion. On a weighted average basis we borrowed through repurchase agreements $3.08 billion or approximately 91% of our assets. We had average equity for the quarter of $512 million and earned net income of $20.4 million for an annualized return on average equity of 15.93%. $20.4 million of net income equated to $0.88 per share using our weighted average per share count of 17,817,000.

On our portfolio we had an average yield for the quarter of 5.03% based on an average coupon rate of 5.29% and average premium of 1.25%. The average principal payment rate was 12.4% which resulted in amortization expense of $1.7 million. Our net borrowing cost including our hedges was 2.7% for the quarter giving us a 2.33% interest rate spread.

Our debt to equity ratio at June 30 was 7.8 to 1 with $4.4 billion of borrowing and $561 million of equity. As Ben mentioned, we have purchased in June an additional $320 million of MBS which we financed on July 2 with an additional $253 million in repo. Including this our repo total is $4.6 billion and compared to our June 30 equity of $561 million gives us a debt to equity ratio of 8.3 to 1.

As a point of clarification one last thing I’d like to mention is how we look at and report the cash flow off of our MBS. As opposed to looking at the constant prepayment rate which involves compounding on a decreasing balance in our view a more understandable and more useful measure we use in our calculation and modeling of yield is the percentage of total pay downs of principal we get over a period. This includes all scheduled and unscheduled principal payments in the mortgage pool.

I’ll now hand this back to Michael.

Michael Hough

With that we will close our opening comments and hand it back to the operator for questions.

Question-And-Answer Session


(Operator Instructions) We’ll take our first question from Bose George – Keefe, Bruyette & Woods.

Bose George – Keefe, Bruyette & Woods

My first question I just wanted to ask about the spread on your new investments and just if you can break that out between the spread you are getting on the hedge portion and the unhedged portion as well.

William Gibbs

If you take a look at the securities that are out there right now we are looking at about 225-230 basis points for new investments at this time and that is looking at about 1/3 hedged at around a 2.5 year swap and the balance in 30/60/90 day floating short-term funding. If you take a look at funding right now, short end of the curve we are looking at about 245 or so for 30 and 60 day repo. If we look at the blended rate on that 1/3 portion of a 2.5 year swap it is somewhere in the neighborhood of about…the blended rate would be about a 284. So that is showing us with looking at around a yield and if we look at our benchmark which we tend to look at around [51 101] type paper benchmark yield will be around 530.

Bose George – Keefe, Bruyette & Woods

At the end of the quarter what was the duration of your assets? The net duration of assets and liabilities?

William Gibbs

Probably just a little bit over one year on the asset side. Around 2 years on the duration and on the liability a little under a year.

Bose George – Keefe, Bruyette & Woods

In terms of modeling our dividend estimates for the rest of the year should we assume a pay out ratio of 90% or 100%?

Kenneth Steele

I think probably 90% at a minimum. We’re going to get to not 100% within each 5-quarter period but I think right now we are targeting at least being 90%.

Bose George – Keefe, Bruyette & Woods

So then I can assume 2009 it would hit the 100% number?

Kenneth Steele

Over any 5-quarter period.


The next question comes from the line of Steven Delaney – JMP Securities.

Steven Delaney – JMP Securities

First, I just want to congratulate you on the quality and depth of disclosure in the press release. I think you are setting, at least with press releases 10 Q aside, a new standard for your peer group and the repo info and the average balance sheet is especially helpful. Thank you very much for that. Just a question on, and I’m really trying to determine the pace and it may be a little redundant but I’m trying to decipher if there is a distinction between your spread on a spot basis as of June 30 as the average for 2Q 2008. You gave us the data for yield and cost of funds for the quarter and the cost of funds was represented as 270 for the second quarter. If I look at Table 5 and Table 6, Table 5 is actually as of June 30, is that correct?

Kenneth Steele


Steven Delaney – JMP Securities

Okay and so if I blend those two together I just ran the math it works out to a blend if we take $1 billion away from the $4.4 billion of short repo a blend of swaps in at 326 and that leaves the residual repo at 254, it works out to the same 2.70. Is that just a coincidence that the spot cost of funds is the same as it was for the quarter?

Kenneth Steele

Yes. That just happened to turn out that way. It was still pretty much in that same target range.

Steven Delaney – JMP Securities

You told us that your asset yield at the quarter end you estimated at 5.03 which was pretty much the same you reported for the second quarter. I guess here is my question, if we are going to look at sort of shifts or changes in the spread for the third quarter we know net interest income will be up because you are now fully invested and you weren’t for the second quarter but just looking at the spread part of it, it would appear the only real room for improvement in the third quarter absent further investment that we don’t know about at this time would be some relief on your 2.48 short repo costs or I guess the continued slow down in prepayment that would help your premium amortization? Is that reasonable to say? These are the only two areas we should look for any possible improvement in the spread?

Kenneth Steele

I think for anything meaningful yes. There are some small things that obviously reinvestment or as some of our expenses maybe get weighted down but for the most part that is correct.

Steven Delaney – JMP Securities

Bill did indicate that you are a little bit higher, 10-15 basis points better on marginal reinvestment today than the 233 you earned at the quarter?

Kenneth Steele

Right. That is kind of where I was leading to with that number.


The next question comes from the line of Michael Widner – Stifel Nicolaus & Co.

Michael Widner – Stifel Nicolaus & Co.

A coupe of clarifying questions on some of the hedging and specifically one of the things you mentioned on the call is I think one you said if you add the swaps and the extended repo you have about $1.7 billion effectively extended funding. I’m just looking at the numbers here on the table and I see $1 billion swaps and then $400 million of extended repo. Just taking the numbers straight off the table am I missing something?

Kenneth Steele

The 1.4 that you are referring to is June 30th. Since June 30th we have increased our extended liabilities by another $300 million and that is where we got the $1.7.

Michael Widner – Stifel Nicolaus & Co.

Is that swaps or extended repo or…

Kenneth Steele

That is $200 million in swaps and $100 million in extended repo.

Michael Widner – Stifel Nicolaus & Co.

Let me just talk about hedging sort of more generally. As we go through the second half of the year kind of looking into 2009 overall market expectations are that sooner or later the FED is going to start tightening. We don’t know how soon or how much but it seems inevitable that the next move is up rather than down in terms of rates. I’m just wondering if you could talk about what level of hedging, I guess probably the most easily expressed as a percentage of your funding that is extended duration, that you would be comfortable with as we approach at whatever point you think the FED is likely to start tightening and whether that is early next year or later this year. Maybe you could give some commentary on that as well.

Kenneth Steele

That is a pretty tough question to answer. When we started back in November and through the first half of the year we kind of targeted 25% extended position. We since increased that to 36% of our liabilities and 34% of assets. Our view is that this is a long-term strategy. We view hedging as a process and we feel like we are appropriately hedged today at 36% and there is no magic number. What we don’t want to do with hedging is we don’t want to come out right now and lock in the spread for 18 months or 2 years and be done with it. This is a dynamic process that as we approach changes in the market and we have our own views and as we evaluate market views we will move to bring that position either greater or smaller. I think we look at it from a duration range that we are comfortable with. It is just not a number that we can peg.

Michael Widner – Stifel Nicolaus & Co.

You mentioned leverage at sort of current spot in time including the July purchases as putting you about 8.3 times. Any sense on whether there is up side to that? Down side? Something you are sort of thinking about as the appropriate range for the rest of this year as opposed to the longer term guidance?

Kenneth Steele

The way we look at leverage as a function of our liquidity and it is not an absolute leverage number. Because of the assets we have and the duration of the assets we have in combination with the haircuts we are paying on our repo and the swap positions we have there is a comfort level in there. Our comfort level is anywhere greater than 5% of our assets. For an example, when haircuts moved in March from the most part from 3-5% our target leverage ratio at the time was 10 and that 10 was a function of the same type of liquidity position of 5-6% of our assets. When haircuts went up 2%, 2% of our liquidity went away so we draw our leverage back down. As long as haircuts are where they are and as long as we have the duration we have on our securities this is a very appropriate number for us. I think we are looking right now in the 8 to 8.5 times range and we will monitor it as we go but I think the relief is going to come when relief comes from the haircut side.


It seems we have no further questions at this time.

Michael Hough

Thanks everyone for being on the call. Thanks for the questions and we look forward to reporting earnings again at the end of the third quarter. Have a nice day.

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