Q4 2019 Earnings Call
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Good morning, I like to welcome everyone to the Arlington asset fourth quarter 2019 earnings call.
Please be aware that each of your line is any listen only mode.
After the company's remarks, well open the floor for questions.
If he would like to ask a question. Please press the Starkey followed by the warranty on your telephone keypad [noise], if he would like to remove yourself from the questioning Q press star too.
I would now like to turn the conference over to rich content. Mr. Konzmann you may begin.
Thank you very much Olivia good morning. This is rich gasman, Chief financial officer of Arlington asset before we begin this morning's call, we'd like to remind everyone that statements concerning future financial or business employment market conditions business strategies or expectation then into guidance on president or future period.
Constitute forward looking statements are subject to a number of factors risks and uncertainties that might cause actual results to differ materially from stated expectations for 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 event or other 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, which.
Available from the company and from the FCC and you should read understand these risks and evaluating any forward looking statement.
I would now like during the call over to rock Tonkel for his remarks.
Thank you rich good morning, and welcome to the fourth quarter 2019 earnings call for Arlington asset.
Also joining me on the call today's Brian Bowers, our Chief investment Officer.
During the fourth quarter as improved economic outlook as a result of federal reserve monetary policies and lower global trade uncertainty.
Led to a risk on move in the global financial markets, which drove an increase in the 10 year us treasury rate and a steepening of the yield curve.
The tenure U.S. Treasury rate increased 26 basis points during the quarter ending at 1.92% and the two to 10 year U.S Treasury curve steepened 31 basis points.
In addition, swap spreads widened eight basis points benefiting agency MBS portfolios hedge with interest rate swaps on the funding side, the federal reserves quarter point rate cut in October along with its actions to provide substantial liquidity to the repo funding markets.
Were significant positive steps to funding in our business.
Against this backdrop.
The performance of mortgages was strong in the fourth quarter as the spread between the yield on agency MBS and benchmark interest rates tighten meaningfully with pay up premiums on specified pools, performing particularly well in light of the rise in mortgage rates.
Since the start of the new year global economic concerns surrounding the impact of the Corona virus and other macroeconomic factors have led to a rally in the tenure us treasury rate and some retracing of the steepening of the yield curve that occurred in the fourth quarter as well as higher market prepayment speed expectations for agency MBS.
Against this backdrop agency MBS have performed relatively well in early 2020.
Threatening to our actual results for the quarter.
We reported GAAP net income of 72 cents per share in core operating income of 18 cents per share.
Core operating income was unchanged from the prior order as the benefits of both lower funding costs and GNS expenses were offset by lower asset yields and leverage.
As of year end book value was $7.86 per share an increase of 7% from September thirtyth, reflecting the tightening of agency MBS spreads.
The company's total economic return measured as the change in book value plus common dividends declared was 10% during the quarter.
As of today the company estimates that its book value per share has increased approximately 1% since December 30 Onest.
Short term recourse leverage measured as the company's repo financing in TV, a commitments less cash to total investable capital has moderated to 8.7 times as of December 30, Onest from 9.9 times as of the prior quarter end.
The weighted average CPR for our specified agency MBS portfolio was 12.11% during the fourth quarter a decline from 12.85 in the prior quarter.
Although our agency MBS asset yields benefited from these lower prepayment speeds.
The weighted average effective asset yield on our agency MBS for the fourth quarter declined to 2.81%.
Compared to 2.96% in the prior quarter due primarily to a shift to lower coupon agency securities.
To begin the fourth quarter of 2020, the company's weighted average CPR was 10.47% for the months of January and February which we expect would result in a weighted average effective asset yield of approximately 2.84% for that period, a modest increase from the average yield in the fourth quarter.
Given current interest rate levels, we expect continued elevated prepayment speeds. However, our transition in the agency MBS portfolio to lower coupon specified pools securities with lower premiums should moderate increases in prepayment speeds going forward and their impact and our shift in strategy to incorporate mortgage cry.
It investments should reduce agency MBS prepayments sensitivity in our book value and earnings overtime.
With its shift in agency MBS investment concentration towards lower coupon securities that carry lower prices pay up premiums and prepayment risk the company's investment in lower coupon two and a half three 3.5% coupon MBS was 72% of its total agency MBS portfolio at.
December 30, Onest and increased from 57% as the prior quarter end.
In addition, all of that component companies agency MBS investments as of year end, we're in specified agency MBS with favorable prepayment characteristics as a company did not hold any generic PVA securities that are more sensitive to higher prepayments.
During the fourth quarter, the company's weighted average repo rate was 2.09% an improvement from 2.46% in the prior quarter as the company's funding costs benefited from the feds rate cuts.
However term repo funding rates were somewhat elevated at year end with the company's weighted average agency MBS repo rates at 2.1% as of December.
31.
Repo funding rates have improved since year end with the Companys weighted average agency MBS repo funding rates at approximately 1.75% currently.
As of December 30, Onest, 83% of the company's repo funding was hedged with interest rates swaps.
And the company's weighted average fixed pay rate of its interest rate swaps was 1.82 during the fourth quarter unchanged from the prior quarter.
During 2019, we highlighted the Companys increased focus on an evaluation of mortgage credit opportunities across various sectors.
Consistent with that during the fourth comp quarter of the company actively shifted its investment strategy to incorporate a broad spectrum of mortgage credit assets. In addition to its focus in recent years on agency MBS.
Initially the company's expanded strategy encompasses specialty mortgage assets across a limited number of selected sectors, which better leverage the company's long standing relationships skills and resources.
Recognizing that the current economic and investment climate is constructive but mature.
We are particularly focused on tailored or directly originated opportunities with attractive and protective credit characteristics and where possible sourced or created in partnership with specialists in their fields with long experience originating underwriting financing and servicing in their investment disciplines.
Arlington has had lengthy relationships with these partners in many cases decades long.
Some of these areas of investment focus may have future branding opportunities for Arlington and its partners as well.
Taken together, we believe a basket of these specialty selected directly originated and tailored opportunities will diversify the company's risks reduce leverage enhance returns and earnings as well as reduced prepayment.
Volatility and repo financing exposures for the company.
These sectors includes specialty real estate lending segments, such as large single asset single borrower CMBS transactions small balance commercial CMBS industry focused and specialized direct originated commercial real estate loans as well as residential.
Operating back mortgages like business purpose residential transition and non QM residential mortgages.
These assets offer significant characteristics.
Such as attractive Ltvs cash coverage and total debt ratios with targeted are always ranging from approximately 11% to 16%.
They also offer diversified funding sources, including permanent financing in certain cases, and they are generally either liquid or offer access to liquidity.
The company began selectively allocating capital to these mortgage credit opportunities with potentially higher risk adjusted returns during the fourth quarter.
As of December 30, Onest capital allocated to the company's mortgage credit investments totaled $57 million, representing 14% of the company's investable capital.
The company's mortgage credit investments as of year end consisted primarily of single asset single borrower commercial mortgage investments and small balance commercial CMBS MBS with attractive risk adjusted returns to start the year. The company has continue to evaluate and add new mortgage credit opportunities as it believes the risk.
Customer returns are higher than current agency MBS returns.
During the fourth quarter of 2020, the company invested in an equity investment in a non agency securitization collateral abides by business purpose mortgage loans also known as residential transition loans.
Secured by residential homes for which the borrower holds the property for investment purposes.
Following these initial mortgage credit investments.
We have observed overall improved returns on invested invested capital combined with a reduction in the overall corporate leverage by almost two turns since the beginning of the fourth quarter.
With this prospect of potential further reductions in leverage as mortgage credit investments expand.
The company is optimistic about the return opportunities available to shareholders from a prudently executed shift to a broader and more active investment strategy, which now includes a discriminate focus on mortgage credit investments as well as agency MBS.
In summary.
The company's initial disciplined investments in mortgage credit opportunities totaled 14% of investable capital with our are always expected of 11% to 16% and attractive credit characteristics.
Second Arlington has sourced or co invested in these initial investments with a number of Premier partners and is currently in discussions with additional potential partners for direct originations of credit assets.
Third observed returns on invested capital have increased and overall leverage is down by nearly two turns following the company's initial mortgage credit investments.
Fourth agency MBS spreads are currently attractive with spreads wider than historical averages.
In addition, federal reserve actions to cut interest rates and provide liquidity to the repo markets have significantly lowered the company's current funding costs.
And a supportive economic.
Landscape should be a tailwind for our mortgage credit investment strategy.
And finally cost efficiencies are available in 2020 to reduce the expects expense burden on capital and enhance the company's returns to shareholders.
In summary, the company is positioned to benefit from improvements in current net interest spread returns in agency MBS.
As well as Opportunistically investing in selective mortgage credit investments at potentially incrementally higher relative returns, which should allow the company to deliver attractive returns to its shareholders.
Operator, I would now like to open the call for questions.
Thank you Sir at this time, we will open the floor for questions. If you would like you asked a question. Please press the star followed by the one key on your telephone keypad now.
Questions will be taken in the order in which they are received.
Thank you would like term these yourself in the question in queue.
Star too.
We will now go to our first question. Our first question comes from Josh Bolton with Credit Suisse. Please go ahead.
Thanks, guys good morning.
I appreciate the disclosure in the deck around the incremental Levered returns on agency versus credit.
Curious do you have a target percentage as capital allocations for the credit segment.
Or how are you thinking about how large that bucket could grow and then additionally, do you have any thoughts around the pace of growth.
That we could see in that segment over the next 12 months. Thanks.
Well, obviously, Josh the.
The pace of investing in the ultimate exposures will depend on.
The.
Market conditions as they evolve over the course of time.
Conditions being as they are today, we would continue to expect that the.
Mortgage credit investment.
Portfolio would grow.
As returns in that segment are at least equivalent to if not higher than agency returns and offer other healing characteristics that I noted in the script.
And so I think.
That would be today, the first focus.
And I wouldn't put a number on it but I wouldn't.
I wouldn't suggest any wouldn't be surprised if they see that portfolio grow and investable capital.
Over the course of the year on a prudent and.
Prudent basis based on where opportunities may be and may grow as high as.
Doubled.
Over the course of.
Over the course of time, that's an ongoing process as you know it's dynamic but.
And it would be a prudent process of a have a potential expansion that portfolio.
But but we can see that it may grow a materially over the course of of the year to the extent that opportunities continue to be relatively more attractive on the credit side versus the agencies.
Got it makes sense and then just one on the interest rate sensitivity disclosure.
Looks like during the quarter the portfolio shifted to be much more negatively exposed to higher rates curious if thats something intentional.
Reflective of your macro view of rates or just any commentary around.
The rate environment, and how how your agency portfolios position would be great. Thanks.
Oh, I guess my first comment to that would be that.
Actual performance in agencies.
In down rates scenarios has probably underperformed versus modeled expectations that you see in these standard.
Presentations and the opposite is true.
The historic recent historical experience has been that they have tended to outperform.
In in up rate.
Or steepening environments to a certain extent and to a certain level.
So I would say that this posture reflects.
The recent experience the.
Convexity embedded in these assets today and the.
And the difference the observe difference between actual prepayment developments and market expectations as rate changes in and curve shape changes have occurred.
I'd say it also reflects a broader commentary.
A broader observation on the macroeconomic backdrop it as a consequence of all those things we've driven the coupon the average coupon the average price the average pay up in the portfolio down sort of programmatically over the last couple of quarters and that's ongoing.
With a focus down primarily to the 3% coupon spec.
Pool block of assets.
Great Thanks to the constructs.
Thank you. Our next question comes from Trevor Cranston JMP Securities. Please go ahead.
Hey, Thanks, Good morning funding. So wondering if you could provide some more color around the new credit strategies in terms of.
You know, how we should expect those investments to be structured and looked at it looks like at December 31 of the assets or to show up on the balance sheet is MBS and mortgage loans.
But I was curious because you describe them as co investments if if the expectation should be that those will continue to just show up as MBS and loans or if there's potential for things like joint ventures to be showing up on the balance sheet at some point.
I think for now probably expect more of of what you've seen described in the financials or that I suppose that could potentially change overtime, but for now.
For the immediate term anyway, I think probably expect to see securities and a mortgage securities in mortgage loans represented as you saw them in the fourth quarter, a rich you have any different commentary on that.
I think I think thats right.
At least for the next quarter, so thats down the road certainly opportunities where.
More of the latter we spoke of driver in terms of.
[laughter].
Yes direct investments in and.
Joint venture type.
Opportunity, we alluded to a this got the discussions ongoing with with new potential investments and partners and.
And some of those would be a lot exactly along the lines of that you've described Trevor.
But those may take a bit of time to further develop.
Okay Gotcha.
And then as these developed and your you said that you're working with sourcing partners.
Should we expect there to be any additional expenses showing up on the income statement associated with the new strategies are how's that going to play out.
Yes, I think.
Rich Trevor.
You may see a little bit more DNA costs.
Associated with that I think theres going to be offset within savings will find and other places.
Certainly the more diligence costs and other types of things that we have to incur.
As relates to expanding it to various mortgage credit opportunities.
I think I think thoughtful down the offset.
In the end by saving you'll see in other places.
No.
No I think I think thats right I think there will be.
Higher somewhat higher costs are around the initiation in origination to those assets and potentially run personnel I don't think I don't expect it to be dramatic at all.
And I do think there are opportunities for other Oh expenses to run run down over the course of 20 as a compared to 19.
And so I think in the end, you'll probably see modal more likely than not you'll see cost savings.
Come through on a net basis over the course of 2020, because I think the potential cost savings will not exceed or meaningfully exceed an incremental expense required to initiate and originate and undertake these investments including potential.
Joint ventures.
Okay got you and then last question on the CMBS structured investments you've made so far can you can you say, where you've been investing the capital structure. If it's more towards first loss first loss type investments or if it might be higher up.
You know it depends its variable I'd say it does include sort of.
Elements of the capital stack down towards the first loss, but in very low ltvs situations.
And it includes non first loss positions in those with a bit higher LTV characteristics and in either what we're looking for in either what we're looking for is the combination of.
LTB seniority ER and cash coverage levels that were entering into a and investment with a higher LTV will then we're expecting that those cash coverage levels would be a quite high.
And other factors that may offset that.
Some of these opportunities are also relatively short and we like the the short sort of relatively short duration of that credit exposure.
And some of the others that are more you no longer have more moderate and attract lower ltvs and other characteristics. So it's a nice blend of duration.
And attachment point.
And generally low external or very low external leverage on those.
And attractive cash flow characteristics are attached in any of the all of those cases.
Okay. Appreciate the comments thank you.
Thank you. Our next question comes from Christopher Nolan with Ladenburg Thalmann. Please go home.
Hey rock when you are on the new current strategy when you're discussing joint ventures, and so forth are you talking about partnering with.
Property developer or so and investing in equity can you clarify that for me. Please.
With the I think it would be along the lines of partnering with originator and servicer.
Hi.
Type folks principally or lenders in particular specialist fields.
That's right thing rather than the equity in a real in commercial real estate development, that's that's probably not topping the list.
Probably not even present on the west at at at the current time, but but investments co investments or joint ventures, with originators Servicers and specialty lenders.
In their field do have long track records or an appealing asset characteristics are the kinds of things.
We have engaged in them and expect to continue to engage in.
Great. Thank you and also on with this new strategy includes.
Things like the Freddie Mac, K series, which would require into the lower tranches, which require.
Consolidation and securitization your financials.
It's something that we that we have reviewed the K series, a we have not participated in it down the thus far I wouldn't rule it out potentially down the road, but thus far it's not been a principal focus date.
And I wouldn't say isn't right at the moment.
All right I'll final question or are we target suite, we really like we feel like we feel like a Chris that we can derive.
Better opportunities in other.
Comparable but not comparable but not K series.
Securities loans.
Finally earlier well a couple of quarters ago, you can't sort of guides for high mid single digit low double digit our lease any update to that.
Well I think we hit on it in the script by alluding to the fact that the returns available in the mortgage credit segment.
At under current conditions.
Seem to us to be in the range of the.
Lower to mid double digits. We stated 11 to 16, we think Thats representative.
I think agency returns on the other hand, while they have improved.
The prepayment speed uncertainty the prepayment speed uncertainty is still meaningful.
And and that.
You know that creates.
You know risks that are different from the mortgage credit environment and.
Probably an 11 as the top end of what one might be able to achieve on a new dollar invested.
In agency in a lower coupon had security spec pool.
So you know you just that volatility.
We feel in the present environment is lower and the credit side and the returns are the same or higher so far experience as bad as I said in the script that they're higher.
With lower leverage.
ER and other appealing characteristics so.
We think sort of the programmatic nature of.
Have evaluating and undertaking originating these assets.
Will be beneficial overtime and to the extent that the agency returns evolve.
Overtime from you know high single digits to maybe 11 at the Max Today, then we'll continue to consider that but for now the primary focus.
Under current market conditions and returns for credit assets would be first on the credit side and the right.
And the ventures and the discussions in ventures, we haven't progress with potential partners as we speak.
Great. Thank you rock.
Thank you. Our next question comes from Jason Stewart of Jones trading. Please go ahead.
Great. Thank you.
Rock you talked about obviously, the joint ventures, it sounds like the truth business migration into credit, but at the same time mentioned that might have been an opportune it sounds like it could've been an opportune time to acquire.
Assets in the fourth quarter could you go through maybe those two.
Different points as it relates to the commercial versus the equity investment and then it sounds like SFR I'm just how those two played out in terms of the cadence of investment that's things, we could get a sense for how that might play out going forward and the return profile.
So weve I think what I tried to say in the script, Jason is that we're investigating across all these spectrums right. So we're investigating the single asset the specialty CMBS single asset single borrower small commercial in particular.
Direct originated tailored or sort of specialized industry car industry specific.
Commercial mortgage loans, that's sort of one bucket and then on the other hand.
Loans that are secured by residential property I eat you know business purpose residential transition loans.
Tensely non QM.
And right at the moment or.
You know SFR is not the top priority, but it's possible where it's in the spectrum of things were evaluating its probably something that isn't top of our lives right at the at the moment, but if we are looking at it and at some point it may be appropriate or if the returns and risks Josh.
The five themselves would that be added to the mix, but not at present, maybe down the road potentially.
Okay. So what's is there any single asset opportunity that's why.
I don't know network.
It was made that again, Jason I couldn't understand the question.
Hi, great hang out with it.
Was there a single investment an opportunistic investment the fourth quarter was that's all part of the strategic thought process.
Oh I say it was up it was in a way to all the above right. It. This was a this was a.
A process that we highlighted for folks over the course of the middle in latter part of 2019 that we're investigating we're undertaking discussions with a variety of parties.
Over that period of time we.
As we completed our that phase of our valuation we focused on these particular areas and in the fourth quarter. We came across some opportunistic situations that that are quite appealing with a with experienced sourcing partners experts in their field and.
ER and that provided a particular opportunity a it wouldn't surprise us to see that.
If we were to see more of those opportunities in a in a the in the course of the first quarter in second quarter of 2020.
I'd say those were more in the realm of on the commercial side and then in 2020. The focus has included the.
Those loans secured by residential properties as well I either the fixing flip a business purpose securitization that we executed.
And continue to look at very very closely.
And evaluate opportunities intimately in that space.
Great. Thank you.
Thank you Mr. toggle there are no more questions at this time.
I would just say Jason one more thing in each of these in each of these silos. What we're speaking is sort of programmatic nature of opportunities with potential partners doesn't mean, we won't be opportunistic on individual situations that come to our attention we will be but we were seeking to develop.
This sort of approach programmatic effort here a across what we think are attractive credit silos with great characteristics and attractive returns and that'll help overall reduce the leverage of the company improve its returns.
And diversify its risk. So those are all programmatic focus is that we're seeking to have in place. Thanks, everybody for your time and if you have any further questions will be happy to answer them.
Post the call.
Thank you Sir and thank you all for your attention. This concludes today's conference all participants may now just cannot.
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