Q2 2020 Arlington Asset Investment Corp Earnings Call

An asset second quarter 2020 earnings call.

Please be aware each of your lines isn't a listen only mode. After the company's remarks, we will open the floor for questions.

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I'd like to turn the conference now over to richer Konzmann Mr. Conference you may begin.

Morning, figuring Mark This is Richard Johnson, 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 performing market condition business strategies or expectation.

In any other guidance on present or future period.

Constitute forward looking statements that are subject to a number of factors risks and uncertainties that might cause actual results to differ materially from the stated expectations for current circumstances.

These forward looking statements are based on management's beliefs assumptions and expectations, which are subject to change risks and uncertainty as a result of possible event or factors. These and other material risks are described in the company 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 and understand these risks and evaluating any forward looking statement.

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

Thank you rich good morning, and welcome to the second quarter 2020 earnings call for Arlington asset also joining me on the call today is Brian Bowers, our Chief investment Officer.

Financial market conditions improved significantly during the second quarter, driven by unprecedented support by federal monetary and fiscal stimulus policy.

Despite the uncertain path of an economic recovery risk asset prices rallied during the quarter with equity markets recovering most of their losses from the prior quarter.

Most fixed income asset classes also recoup some of their prior quarter losses as credit spreads generally tightened during the second quarter.

And the federal reserve signaled its intention to keep short term interest rates at their current level for the foreseeable future leading to low interest rate volatility and a slight steepening of the yield curve during the quarter.

Agency mortgage performance was mix for the second quarter elevated prepayment expectations adversely impacted higher coupon agency MBS, resulting in generic lower coupon bonds outperforming their higher coupon counterparts.

Agency MBS backed by specified pools like those Arlington owns outperform generic Tvs as pay up premiums for specified pools increased significantly during the quarter as a result of the federal reserve rate cuts and ongoing support for repo operations repo funding for agency MBS remains raw.

Mobile AD lower funding costs.

While the current landscape for Levered agency MBS investing has improved from last quarter certain investment risks have also increased including the uncertain path of prepayments in the lower interest rate environment and higher pay up premiums embedded in the current pricing of specified pool.

With the improvement in the financial markets during the second quarter values of most mortgage credit asset classes were covered some of their losses from the prior quarter, reflecting a general tightening of credit spreads. However.

There continues to remain lack of clarity in the timing and the degree of the reopening of the economy and its resulting financial impact on both residential and commercial mortgage borrowers.

Accordingly, there is uncertainty surrounding the timing and magnitude of any credit losses in mortgage credit assets.

Despite the positive economic impact of federal monetary and fiscal policies on current market conditions.

The company continues to believe that the full financial ramifications from the varying degrees of shutdowns across the U.S economy may not be appropriately priced incurred investment spreads in certain fixed income assets.

As a result, the company has continued to maintain a relatively cautious stance dance, which prioritizes preservation and protection of the company's balance sheet through low leverage and substantial liquidity.

Accordingly, the company is continuing to take a selective approach the redeploying that capital or increasing leverage significantly in the current environment.

Turning to the actual results for the quarter. The company reported GAAP net income of 26 cents per share and non-GAAP core operating income of one cent per share.

The company's book value with $5 in 63 cents per share as of June Thirtyth, a 7% improvement from last quarter as both its agency MBS and mortgage credit investment strategies recovered some of their losses from last quarter.

During the second quarter. The company also made accretive repurchases of its common stock repurchasing 3% of its outstanding common stock.

The comedy continues to maintain a low leverage profile with its short term secured financing to investable capital ratio at 1.2 to one as of June Thirtyth.

In order to maximize its liquidity the company did not declare a dividend on its common stock during the second quarter accompanies common stock dividend paid on February 3rd combined with its tax loss carryforwards provide the company with flexibility in managing its read distribution requirements. This year.

The company will evaluate future common and preferred stock dividends on a quarterly basis based upon multiple factors, including the overall economic and market conditions.

Return opportunities on investments, it's ongoing liquidity needs and reap distribution requirements.

The company was encouraged by the performance of both at the agency MBS and mortgage credit portfolios during the second quarter as both that positions benefited from spread tightening and attractive investments made during the quarter, while continuing to operate with overall low leverage and financial flexibility.

During the second quarter the company increased its capital allocation the mortgage credit assets by Opportunistically investment investing in new investments at attractive risk adjusted returns.

As of June Thirtyth, the company's Investable capital was allocated 62% to agency MBS and 38% to mortgage credit investments.

Although lower repo funding costs have improved current return on equity opportunities and agency MBS.

Pricing has become relatively expensive due to the federal reserves support through its substantial purchases of agency MBS.

Within its agency MBS investment portfolio the company decreased its allocation to higher coupon securities during the second quarter as elevated prepayment speed expectations have significantly diminished the return opportunities in this end of the coupon stack.

In the agency mortgage market. The company currently sees greater return opportunities in lower coupon bonds with available Levered returns in the high single digits.

Notwithstanding the credit protection and liquidity associated with agency MBS with available Levered returns on a new dollar invested generally in the high single digits with appropriate leverage we remain relatively cautious on Levered agency MBS exposure.

The composition of the company's current credit mortgage credit investments consist of a balanced portfolio of non agency MBS collateralized primarily by residential.

Commercial mortgage loans financing collateralized by mortgage servicing rights and of.

And a commercial mortgage loan, which is performing fully in line with initial expectations.

The company is actively evaluating investment opportunities across various asset classes, including mortgage related investments specialized collateralized investments and other potential platform investment opportunities as they develop in this evolving investment environment.

During the second quarter, the company observed attractive return opportunities in mortgage servicing rights and financing for MSR as the values of mortgage servicing rights declined due to the elevated prepayment expectations and uncertainty surrounding servicers ability to meet servicing advances associated with antenna.

Debated borrower default and Forbearances, which then led to spreads on the financing of MSR assets widening meaningfully.

MSR financing investments typically consist of term senior notes securitized by mortgage servicing rights that also carry a corporate parent guarantee.

The company took advantage of attractive risk adjusted returns available in MSR financing opportunities.

Significant collateral protection by making several new investments in this asset class during the quarter as of June Thirtyth, The company held $64 million of MSR financing investments.

And the company is continuing to evaluate additional attractive investment opportunities related to mortgage servicing rights.

Either through direct investments in MSR or financing is collateralized by MSR.

The company does not currently have significant repo funding exposure in its mortgage credit investment portfolio.

As of June Thirtyth. The company did not have any outstanding repo funding on any of its non agency MBS or MSR financing investments.

The company's sole funding exposure on its mortgage credit investment portfolio consists of $32 million.

Of repo funding for commercial mortgage loans with strong credit statistics with a repo funding maturity in May 21 that has had no margin calls today.

While the dislocations in the financial markets from the Cobiz 19 induced economic shutdowns.

Have laid the foundation for attractive investment opportunities in certain mortgage related and other credit assets.

The company believes certain credit assets may not yet it fully priced in the effects of the economic outlook.

We are executing on a plan of a selective approach that focuses on current investments would provide acceptable returns on capital and will enable the company to deliver a positive economic return to shareholders.

Overtime, while retaining sufficient liquidity that will provide the company with ongoing ability to capture attractive investment opportunities that may arise across sectors as economic conditions evolve over the coming quarters.

In summary, the company's high level of liquidity in low leverage and ensures the company is well positioned to take advantage of attractive investment opportunities that may be created as a full economic impact for the current economic downturn materialize.

And should enable the company to deliver attractive risk adjusted returns to shareholders overtime.

We'd be happy to take questions. If you have.

At this time.

The floor for questions.

To ask a question. Please press the star followed by the way.

On your Touchtone phone now.

Question will be taken in the order in which they are overseas.

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Well take our first question from Doug harder with credit Suisse.

Thanks, Rob can you just talked about.

How obviously you did buy back some stock during during the second quarter, how you're thinking about additional share repurchase and how does the attractiveness of share repurchase compares to.

The investment opportunities you just talked about.

Sure.

Morning, Doug.

Well I guess, I'd say too I guess I'd say two things one.

Obviously capital.

He is a precious commodity.

And reducing scale.

By repurchasing a securities on the balance sheet.

Has to be something that we're very deliberate about given our scale. So.

We start with that part of the equation, having said that I'd say secondly that as we sit here today I don't think we're really viewing the world a much differently markets and.

And our stock in our circumstances versus markets much differently than we were during the second quarter. So I'd say generally our orientation and our thought process, who would be reasonably in line with the with the where it was while we were executing that process.

In the second quarter.

Great and can you just remind us how much authorization you have remaining on on your by under for buybacks.

So.

At the end of.

At the end of the quarter I think there was probably give or take a million shares left.

And we've we've undertaken a new authorization.

As well.

Which you'll see disclosed.

I think later today or.

Later today.

Okay.

Thank you correct.

And we'll take our next question from Trevor Cranston JMP Securities.

Hey, thanks.

Yes, you guys talked about some of the reasons lawyer somewhat cautious on the agency space at the moments.

Can you sort of add some color around how you you know away the factories in assets, maybe a little bit overpriced with the fed in the market versus the cost of giving up the to carry income.

Associated with Relevering that book.

And maybe just talk a little bit about sort of what you'd be looking forward to see too.

Start adding to that portfolio again thanks.

Sure.

Well, let's see I think.

I don't know than I would say our thoughts are terribly align with maybe some others a couple a a couple of things one obviously the government.

Is heavily involved.

In the net supply.

Relation.

And that's had a very powerful effect.

On stabilizing both sides of the agency equation prices as well as funding.

And I think on one hand, you know if one was to contemplate whether you think that that a bit of that influence is likely to continue to be there for a while I think we and others were probably conclude that probably will be around for a while I don't think the government is probably indicated Denise.

Given any indication that is.

Tends to pull that supporting him soon having said that.

All of US who've been around this space no that the government where to give any moves even a slight as Tim.

Pulling back that could have a.

You know a negative effect on pricing the other factor here.

As I think we're all aware is the is the uncertainty around speed.

And so as we sit here today.

Let's take the low end of the coupon stack, which we probably find appealing at Innospec to add you know somewhere around 105.

But with a market expectation on maybe in 11 speed or something like that.

You know if it all goes according to plan, maybe you can generate.

Well, one in a quarter ish type yield off of that.

Which you know seems like it's not it's reasonable, but we've also all observe that speeds.

The path of speeds as can be pretty uncertain here recently and so it's not.

Outside of the Rumble profitability that that could.

Level.

And if it doubles than your yield is now probably you know closer to one or even potentially you know below but it's certainly down toward 1%.

And with funding and hedging associated with that.

You're probably talking about cash funding, that's going to be in the high teens or 20, something like that if you're no nothing on where you are for us since probably in the Twentyth.

And then if you're hedging half of that from a duration perspective than you know you're looking at something on a blended basis, which is going to be in a thirtys.

And I think that tells you that that all adds up to.

And our OE that on an appropriately levered basis is going to be in the high single digits and from our perspective as we look at other alternatives.

We view that we are we still believe we're able to generate from a selective approach to alternatives to the agency.

Cash carry that's going to be in the mid single digits on an unlevered basis.

And potential upside from discounts associated with that which gets you ideally towards double digits, but not in every case, but would would likewise gets you into that high single digit category.

Sure.

Other other non agency assets that can deliver on an unlevered basis carry of double digits without really a discount so you're not likely to gain a lot of upside, but we can generate carry on an unlevered basis, it's going to be.

At least touching if not more than touching the double digits and so as we balance the equation, we're looking at agency.

High single digits with a significant amount of variability around speed expectations in there and therefore.

Net profitability from that asset and potential movements in capital related to that speed volatility.

Even as the government provides a stabilizing influence a powerful stabilizing influence across both sides.

The the key equation for agencies that we balance that against the return profiles that I just illustrated in the non agency side and we also balance that against the securities under on balance sheet and and I think the result is what you saw in the second quarter in which we essentially doubled the size of that.

Taleo with those exact metrics in mind.

Mid to high single digits carry with some discount associated with it now those assets have become more expensive.

Which is why you saw the growth in book value and the economic return of at the level you that we did.

So that equation is a little bit less favorable today than it was.

Two months ago, three months ago, but it's still stands its still stands and that is the that as the equation that we are thinking about all the time in so agency has absolutely has a place.

But the other two alternatives are also.

Have a role to play in that in our portfolio allocation process, as well and sustaining a meaningful amount of liquidity and low leverage to take advantage of opportunities or dislocations as they arise is also a priority for us. So that's how we're thinking about it that's what is the driver behind.

Not re levering the agency portfolio, maybe up back to levels that it historically had been or along that pathway.

And I think in line with that we view ourselves is on a very deliberate and deliberate approach of making selective asset investments in the types of profile asset profiles that I outlined.

That will occur over the coming to the three quarters, or so and and provide a ramp in our allocation as well as they ramp in the earnings profile the company to to accompany that.

Okay, great. Thank you.

And then just another question on the mortgage credit portfolio.

You know the two new asset classes, you added there the bigger on being the MSR financing and then also some of the resi MBS.

Looks like both of those are carried pretty close to par value.

Can you talk about what's your expected unlevered yield is on on those new assets that you bought during the second quarter. Thanks.

Well there carried at fair value.

And just so I'm I'm clear on the question Trevor you're asking about the give or take $75 million of incremental assets that were added.

From quarter end of quarter end is that what you're describing.

Yes exactly.

And you are asking what the cash carry is or the total expected return on those.

Well I, both I guess, the sort of due to yield you will be amortizing and and I guess, what's your expected total return but.

Oh, well to blend right. Some of them are straight straight coupon instruments and those are going to be in a mid to high single digits call. It.

Call It six a six and a half maybe some a little higher than that.

And then others are going to be a combination of current an upside and those are going to be little bit lower occurrence, maybe but with the discounts those are going to be high single digits and some in the some in the teens.

So I'm, just I'm, sorry, not teens double digits, but I'd say the range for those that don't have.

Just kind of upside would be.

You know six and a half.

766 tend to have seven something like that and.

The those assets a do carry discount to be a little higher than that 789.

Okay, Great and then the last question just back on the agency book.

Let's say you guys have.

Significant significantly smaller hedge portfolio relative to the agency book than you have historically.

Can you talk about your approach to hedging right now and kind of where your interest rate sensitivity.

Oh right now we're in a 0.2 positive GAAP.

And.

In that.

With with all the elements that I described before it's it's slightly positively.

Directed and and with most of that is in the long end that hedges, mostly in the long and as you can see.

You'll you'll see it if it's not enough if you didn't see in the release of you'll see them the K in the Q.

It's Mike it's more of a 10 year focus.

Okay got it thank you.

And we'll take our next question, Jason Stewart with James training.

Good morning, gentlemen, on the credit side of the investment book, what its current term financing look like and now how does that driving the impacting the opportunities that you evaluate.

Well.

I guess first we're not really putting financing on the credit side of the book generally.

There may be exceptions to that but.

That portfolio is essentially unlevered, except for the one piece of repo on one or on the on the only commercial.

Mortgage that we have so.

We're not really focused on layering in a lot of repo financing external financing I should say nonstructural financing on the on the credit side of the portfolio. If we were I think you'd be looking at financing rates that would be in the near 300 basis points range something like that maybe.

The 350 on some and depending depending on whether on the credit stack, if they're really senior like.

Take up a really senior RPL bond you know that's gonna be closer to two ish.

And those that are mid little bit further down the stack might be three three and a half.

Those are that would be against assets, they're going to carry.

Mid to high single digits, Carrie and if you're going to lever and you'd be leverage them against the three 3.5% cost of funds or something like that but we're not doing that and I don't think we anticipate doing that.

Soon.

We don't have a need with this level of liquidity on the balance sheet.

Got it I guess I was just thinking more down the road. If you did apply leverage what the what the NIM would look like on it and it sounds like it's pretty attractive.

You know as a broad matter, Jason I think it'd be fair to say, if you assumed a five or six Kerry something like that it's just an example against day three three and a half a net cost that probably would be a fair assumption, we're not doing that today, but that could be possible down the road.

Okay.

Thank you Sir.

Thank you.

Next question from Christopher Nolan with Ladenburg Thalmann.

Rock clarify on Hey, doing.

And your comments I appreciate the detailed comments you gave on the new strategy, but when you are mentioning high single digit returned for RMBS was that unlevered.

Oh, you mean on the credit side on the on the other non agency yes.

[noise] not some of those assets may have some they may have some structural leverage on them in some cases, but but in many cases not that will those would be those would be unlevered.

Ross either carry or a combination of Carrie and a discount realized as upside over time.

Okay, and then I guess.

I just trying to get my hands around the strategy given how the.

MBS market has evolved in the second quarter given.

The decline in repo funding costs.

And it seems to me just boiling it down you're making a bet that prepayments are going to materially increase so impacting RMBS and that the U.S. economy will recover which will enable you to keep your credit losses manageable is that a reasonable way to look at this.

Uh huh.

Ooh Yeah.

Possibly meaning.

Prepay speeds.

Our uncertain.

And while one.

Can fund these assets at attractive levels on a repo basis.

They still have to be hedged a 2% asset.

2% spec pool, which today would probably be the asset of choice.

Either two or two and a half, but let's use the two for now given where rates are markets prices.

And yields are.

The that as an asset that's going to require significant hedge.

And so by placing a significant hedge on that you're right you're raising the cost of funding and therefore shrinking the net spread available on that asset.

And so if you get that combined with.

Some potential elevation and expected speeds from the number I use before which was an 11 to say a 15.

You will realize a less spread than you.

May or May believe you bargained for upfront.

And it could be real quite significant.

So the returns there are just less risk less predictable than maybe they are they appear on the surface and maybe than they have bandit points where.

Theres been a bit wider spread opportunity now others have a different view on it and and obviously they are expressing a quite different view in their allocations.

But we look at it that the combination of those uncertainties around those speeds in those net resulting spreads on the capital volatility that can occur from that.

Justifies an allocation.

That doesn't require a great deal of leverage.

In the agency.

And at the same time provides the opportunity to capture comparable returns and in some cases, maybe higher returns.

On an unlevered or very low leverage basis on the eight on the non agency side with a with liquidity, albeit less than the agency side, but some liquidity as these are two steps.

Or.

By entering into opportunities that may not have accused that may not have the same liquidity can offer double digit returns.

Either in pure Carey or in a combination of carry and discount upside. So those are sort of the three sets of types of alternatives that we're looking at as well as platform opportunities that identified in the script and but those are the those the opportunities that we focus on and at the same time, we're focusing on.

The balance sheets security center on balance sheet us.

And balancing each of those day by day.

And also just a clarification you might mentioned earlier what are the what type of assets are you buying at a discount hoping to.

Clicked on some discount accretion.

Well, there principally residential in character, a they're almost exclusively residential and character but.

So I mean, there there they are common residential assets, we're not focused right now in the commercial side, our commercial exposure is very small.

And I gave commentary in the script on the the one commercial loan that we have this performing very well.

And has a a repo facility that extends out you know.

Just a year.

So our focus is primarily residential and residential related.

Assets, either CUSIP or non CUSIP and then also we're focused on platform opportunities that.

That that we've identified and continue to evaluate.

Great addition to agent locations.

Thank you.

Just to talk a lot there are no more questions at this time.

Thank you very much.

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

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