Q3 2019 Earnings Call

Marks we will open the floor for questions. If he would like to ask a question press. The star key followed by the one key when you're Touchtone phone. If you would like to remove yourself from the question in queue Press Star too I would now like to turn the conference over to Richard Konzmann Mr. Konzmann you may begin.

Thank you very much and good morning, Rich constant 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 condition business strategies or expectations and any other guidance on president or future periods constitute forward.

There are subject to a number of factors risks and uncertainties that might cause actual results to differ materially from stated expectations are 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 are factors.

These and other material risks are described in the company's annual report on Form 10-K , and other documents filed by the company with the FCC from time to time.

You are available from the company and from the FCC and you should read and understand these risks when evaluating any forward looking statement.

I would now like turn the call over to rock Tonkel for his remarks.

Thank you rich good morning, and welcome to the third quarter 2019 earnings call for early from assets also joining me on the call today is Brian Bowers, our Chief investment Officer.

During the third quarter, the continuation of a weakening global economic outlook ongoing trade tensions and declining inflation expectations.

The federal reserve to lower its target fed funds rate twice during the quarter and once again at the end of October . Despite these actions by the fed the yield curve continue to flatten during the quarter.

The two to 10 year Treasury curve declined by 22 basis points to four basis points as of quarter end as the weakening economic outlook drove long term interest rates meaningfully lower leading to heightened interest rate volatility.

Inter quarter, the 10 year Treasury rate fell 55 basis points.

246 basis points in early September before retracing some of that rally the closed at 1.66% as of September Thirtyth.

A decline of 35 basis points during the quarter.

Prepayment speeds on mortgages increased significantly during the quarter in response to the strong rally in interest rates through the course of the year as well as normal seasonal patterns.

In Mets in mid September a much publicized market dislocation in the repo funding markets.

Led to a substantial spike in overnight government repo rates were fed responded by adding substantial liquidity the stabilized repo funding markets through its open repo market operations and announcing its intentions to expand its balance sheet.

A very positive step for funding in our business.

Hi, prepayment speed expectations heightened interest rate volatility on a flat interest rate curve led to an increase in risk premia in mortgages, resulting in agency MBS underperforming interest rate hedges during the third quarter.

While the company shifted investment concentration towards lower coupon and specified agency securities mitigated the impact of the company's results for the quarter, both higher coupon and generic PVA Agency Securities underperformed lower coupon and specified agency MBS with favorable prepayment characteristics.

During the quarter.

Since September Thirtyth agency MBS performance relative to interest rate hedges has been flat to modestly improve.

And continued flattening of the interest rate curve elevated prepayment speeds and higher repo funding rates relative to LIBOR had the effect of compressing net interest spread returns on the Levered agency MBS during the quarter.

However, while these pressures continue to weigh on part portfolio returns since September thirtyth funding conditions have ease and return opportunities on new investments have improved as yield curve as steepen repo funding rates have declined materially and agency MBS spread widened during the third quarter is captured on new investments.

Turning to our actual results for the quarter, we reported a GAAP net loss of 23 cents per share and core operating income of 18 cents per share as of September Thirtyth book value was $7.35 per share, reflecting the modest widening of agency MBS spreads relative to benchmark.

Interest rates.

Short term recourse leverage measured as the company's repo financing and TV a commitment less cash to total investable capital was 9.9 times as of September Thirtyth.

The decline in core operating income from the second quarter was due primarily to lower average leverage and lower average asset yields partially offset by much more favorable net funding costs. The companys average leverage during the third quarter was 10.1 times a decrease of over 1.5 turns from the prior quarter.

The weighted average CPR for our specified agency MBS was 12.85% during the third quarter, an increase from 10.16% during the prior quarter as a result of these higher prepayments speeds as well as the shift to lower coupon agency securities the weighted average effective asset yield on our age.

Agency MBS portfolio was 2.96% for the quarter a decline from 3.21% in the prior quarter.

The company's weighted average CPR for October and November was 13.46, which we expect could result in a weighted average effective yield of approximately 2.78% for that period.

Given current interest rate levels, we expect continued elevated prepayment speeds, but our transition to additional lower coupon specified pools securities with lower premiums should moderate increases in prepayment speeds going forward.

The company's continued shift towards lower coupon securities that carry lower premiums and prepayment risk increased the company's agency MBS concentration in lower coupon, 2.5%, 3% of Freeney AFE percent MBS to 57% of its total investment portfolio at September Thirtyth.

An increase from 27% as of the prior quarter end. The company also increase this portfolio concentration of specified agency MBS with low prepayment characteristics during the third quarter, while significantly decreasing its exposure to generic agency Tvs that carry higher prepayment risk.

As of quarter ends 98% of the company's agency MBS portfolio is comprised of specified agency MBS.

Compared to 86% as over the prior quarter end.

While repo rates were lower during the third quarter, reducing interest expense on an unhedged repo repo rates relative to LIBOR remained somewhat elevated and above the receive rate on the companys interest rate swaps offsetting the repo interest benefit in that period during the third quarter the company.

Is weighted average repo rate was 2.46% and an improvement from 2.64% in the prior quarter. However, as a result of the feds actions to both lower the federal funds rate by 75 basis points since the start of the third quarter and to provide substantial liquidity to the repo market.

Current repo funding rates and conditions have improved materially.

Today, one month repo funding rates have improved to approximately 185 basis points versus the average rate on our repo balance at September Thirtyth up 235 basis points.

As a reminder, the company enters into interest rate swaps for which it pays a fixed rate in receives variable rate based on three month LIBOR in order to lock in its funding cost proportionate with repo funding for the length of the swap.

From late in the second quarter through the third quarter, the interest rate swap market price than expectations for multiple federal reserve caused leading to a significant conversion in the short end of the interest rate swap curve versus repo funding costs.

The company took advantage of this opportunity by increasing in short term rates swap positions by approximately $1.1 billion during that period to effectively lock in much of the markets.

Previously anticipated federal reserve cuts into its net funding costs.

As of September Thirtyth, 81% of the company's repo funding was hedged with interest rate swaps.

And as a result, the company's weighted average fixed pay rate of its interest rate swaps was 1.82% during the third quarter a decrease from 2.1% during the prior quarter.

While spread pressures for agency MBS do remain the outlook for return opportunities on new investments today.

As improved for several reasons first the feds three rate cuts since the start of the third quarter lowered current funding cost appreciably second.

Beds recent actions to stabilize the repo markets have improved repo rates relative to LIBOR benefiting net funding costs for agency MBS.

Third the widening of one month to three month LIBOR since quarter end also benefits net hedged funding costs.

For the yield curve is steepen with the two to 10 year treasury widening over 20 basis.

Points since September Thirtyth.

And fifth the mortgage prepayment speed expectations have begun to moderate.

In summary of the company is positioned to benefit from improvements in current net spread opportunities and agency MBS, which should allow the company deliver attractive returns to its shareholders. Operator, I would now like to open the call for questions.

At this time, we will open the floor for questions. If you would like to ask a question. Please press the star key followed by the one key on your Touchtone phone now questions will be taken and wondering which they are received if at any time you would like to remove yourself for your question in queue, Chris starting.

Our first question comes from Jason Stewart with Jones trading.

Hey, good morning, guys.

20, Jason.

But on the on the leverage on noted in the quarter I mean net settlements it looks like so.

Leverage down on average to the quarter, but at period end, we're sort of heading into this environment, where youve listened a lot of positives leverage is already up I guess my question is are you comfortable with where it should.

Average out during the fourth quarter based on September Thirtyth or is there more opportunity to increase leverage based on your views the investment environment.

I think Jason is there certainly the potential increased leverage some I'm not sure I would.

Bob.

Suggest people expect that I think we may I think it's just it's likely that we remain about where we are.

Or about where we sort of where are the at the beginning in the quarter, which was somewhat increased from the.

Third quarter.

Excuse me from the second quarter, but roughly in line with the third quarter and and with the potential.

As spread opportunities improve that we may increase that at the margin I would say I would emphasize at the margin we.

We've been clear overtime that we expected that no one should be surprised us overtime leverage came down I think that's been the case.

I think we're comfortable approximately where we are but we do have the flexibility to move up a little bit.

If we deem it best given spread opportunities.

Understood understood and then on the repo funding a you know we typically see some pressure.

Going into year end as dealers steel with inventories.

This year is a little bit different I think your average repo was a little less than 30 days have you started taking anything over yearend <unk> and your comments it sounded very positive into markets, where functioning well I'm just wondering if youve executed over here and then seeing any.

Any prints in that market.

Over that date.

There is year end over at year end repo available.

I Wouldnt say, it's a massively thick market from what we can tell right now we have started that process.

We expect to increase that process over the course of the month.

And the quarter, so we've gotten underway.

But but.

It's not yet clear how deep that market is through year end and I think a you know the potential for some pressure over quarter end still does exist I think the overall repo market is far healthier than it was but there are still.

There are still the potential for pressures around year end, we're working on alleviating that ahead of time as best we can it we've begun that process.

Right, that's that's fairly normal, but it's fair to say that you didn't see much impact from the hiccup, then you're not necessarily expecting to see much impact.

Outside of normal.

Seasonality going into this into the fourth quarter is that fair.

Yes, that's fair.

Okay cool. Thank you very much appreciate it.

And I would say this week, we been Oh, we blunt pleasantly surprised by the.

Over year end levels that we have seen so far.

Great. Thank you.

Thank you. Our next question comes from Mikhail Goberman with JMP Securities.

Okay. Okay. When your line is life.

Right.

Got a question Michael and you can hear as you can feel free to call us offline.

Take our next question from Christopher Nolan with Ladenburg Thalmann.

Rock given the Crown, Mike Hey, I'm.

Hey, rich is given to the migration to mid coupon RMBS is the guidance that you gave last quarter for low double digit high single digit.

Returns on book value still hold doors or change on that.

Well, there's lot of variables in that as you well know up you know forward occur outside how how pet funds and repo spreads play out those are important and Ah I think.

The prior question and answer sort of responded to part of that equation speeds are relevant portion of that speeds continue to be elevated.

And we'll see how that progresses over the course of the fall or the rest of the fall pardon me and when the seasonal pattern start to kick in there may still be a bit of pent up a.

Refinancing the flow through the system in the or in the next month or so.

And then maybe after that we started to see the seasonal effects come into play and help help out on the yield side with.

Somewhat reduce prepayments at that stage I think overall that that that arena for or are we returns.

It's probably fair I think today at the margin.

They would probably be as they can these conditions at the higher into that range for new investments.

But we've also seen that return opportunities have moved around over the course of the last few months as the market has adjusted to new fed policy.

Today, they are in fact, as though higher into that range.

And and those are the.

Based on the key points that we pointed out you know our in our script.

Okay. Thank you that's it for me.

Once again like to ask a question. Please press star one our next question comes from Mikhail Goberman with JMP Securities.

Hello, gentlemen, can you hear me.

Yes, we can.

Excellent sorry about that not sure what happened there. Thanks for taking my question can you potentially give an update on our book value performance in the fourth quarter so far.

You're seeing.

I think it attracts what I said in his script.

You know more performance.

Through the maybe the middle part or maybe a little later part of October was a weaker.

And since that time has been a considerable considerably stronger.

To the point that I'd say overall since September thirtyth.

Performance is flat to modestly improve.

Great. Thank you for that and maybe some thoughts on what you're seeing in TB a versus spec pools today.

Well today, we would still favor spec pools.

The prepayment.

Risk a in the TV a side continues to be.

Somewhat challenging and.

Returns are.

Body through the coupon stack shall we say some are negative.

And some are slightly part of positive, but the but Kerry.

Pretty meaningful.

Prepayment risk.

From the universe for broader universe, So we would still continue to favor.

Second rules here.

[noise] gotcha, Thank you and <unk>.

For the prepayment protection.

Right.

And I apologize if you had covered this before my line cut out for a minute or two earlier, but what does your outlook for prepay speeds in the fourth quarter a lot of a bunch for your peers have sort of mentioned that.

October was pretty high November could be pretty high as well, but you know you expect kind of a huge.

Seasonal drop in December but has it as a whole what do you expect for the fourth quarter.

I just wonder if you hit on that with my prior response.

I think our best judgment around it would be that first of all the October and November speeds, meaning September October that were ordered in early October November were about the same.

They're about relatively flat and we alluded to that in the script at about 13 and little under 13 and a half.

Yes, and we wouldn't be surprised if those elevated speeds continued.

For a bit later into the year this year than maybe in some others.

As a consequence of the pipeline.

Uh huh.

Financing activity mortgage financing activity, that's built up in the system. So there might be so some of that volume to come through from the lower rate environment over the next month or may be too, but we would expect after that to see the seasonal effect take place.

And late in the year those speaks to come down.

Seasonally and and through the first quarter all of that would depend on rate levels of course, so rate levels, lower probably wait and a higher speed in rate level prior probably equation somewhat lower speed.

I think a from a calendar perspective, we would see elevated speed through the fourth quarter and then moderating late in the fourth quarter and into the first.

Great. Thank you very much thank you free time.

You bet. Thank you.

Thank you Mr. telco there are no more questions at this time.

Okay, well. Thank you very much everyone. We appreciate your time, if you have any further thoughts or questions. Please show them a offline. Thank you.

Thank you ladies and gentlemen. This concludes today's teleconference. You may now disconnect.