Q4 2020 Arlington Asset Investment Corp Earnings Call
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You are now rejoining the main conference.
Good morning, I'd like to welcome everyone to the Arlington asset fourth quarter 'twenty 'twenty earnings call.
Be aware that each of your lines is in a listen only mode. After the company's remarks, we will open the floor for questions. If you would like to ask a question. Please press star followed by one on your telephone keypad.
If you would like to remove yourself from the questioning queue press star two.
I would now like to turn the conference over to Richard Cosmen. Mr. Cosman, you may begin.
Thank you very much and good morning. This is Richard Johnson, Chief Financial Officer of Arlington asset before we begin this mornings call I would like to remind everyone that statements concerning future financial or business performance market conditions business strategies or expectations and any other guidance on future price on present or future periods 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 risk and uncertainty as a result of possible events or factors. These and other material risks are described in the company's annual report annual report on form 10-K, and other documents filed by the company with the SEC from time to time, which are available from the company and from the SEC and you should read and understand these risks when evaluate.
Any forward looking statements.
I would now like to turn the call over to rock comparable for his remarks.
Thank you rich good morning, and welcome to the fourth quarter 2020 earnings call for Arlington asset also joining me on the call today is John Murray our portfolio manager.
During the fourth quarter optimism for both additional fiscal stimulus and a successful vaccine rollout along with continued monetary support led to a market expectation of a pending economic recovery.
Asset prices extended their rally from last quarter with equity markets, continuing to strengthen and credit spreads on most fixed income asset classes tightening while the yield curve steepened and long term interest rates rose in response to the improved economic outlook.
With low interest rate volatility and ongoing federal receive reserve balance sheets support agency mortgages performed well during the fourth quarter with repo funding for agency MBS readily available at attractive funding costs.
However, there is elevated investment Rick at risk in agency mortgages that trade at historically high premiums to par and are dependent on ongoing purchases of agency mortgages by the federal reserve combined with an uncertain path of prepayments and the low rate environment.
Mortgage credit asset values also generally increased during the fourth quarter, reflecting overall tightening of credit spreads and a positive sentiment towards risk assets.
Residential mortgage credit assets continued to be reported by strong home price appreciation.
And low mortgage rates.
Overall, the general theme of an improved economic outlook led to a strengthening of values across financial assets with spread tightening reducing the expected return profile with new investments going forward. However.
However, the company believes that there are investment opportunities available at this time in this environment that can deliver attractive returns to shareholders overtime.
The company's goal is to build an investment portfolio with multiple sources of income.
Which complement our agency MBS portfolio diversify risk and improve the level and reliability of returns.
The company expects to complement its allocation of capital in agency mortgages by redeploying portions of its liquidity currently in the form of unencumbered agency MBS into its other targeted investment strategies, including mortgage servicing rights mortgage credit and other financial asset classes.
We expect to maintain a strong stable and liquid financial position by keeping leverage low and financial flexibility high while utilizing term non margin financing structures where available.
In addition, the company is focused on creating partnerships our platforms, where possible to promote the predictability of investment flows growth and the potential for compounding value creation opportunities that layer on top of the current investment returns embedded in the company's investments.
Before discussing the results for the quarter in more detail I'd like to note a few highlights. The company produced is approximately a 7% economic return, while maintaining complete financial flexibility low leverage and a strong secure and stable balance sheet structure.
We established high return investment channels in mortgage servicing rights and completed initial investments in MSR through a strategic relationship with the GSE servicer from which we currently expect unlevered double digit return opportunities.
And the potential for appreciation.
As well as ongoing MSR opportunities the company continued to repurchase shares of its common stock at accretive prices ultimately repurchasing 10% of outstanding shares during the year.
And the company improved its cost structure, leading to a reduction in G&A G&A expenses by 16% for the year with additional potential savings in 2021 that are expected to reduce expenses by approximately 25% over a two year period.
For the fourth quarter. The company reported net income of 32 per share and core operating income of <unk> 12 per share.
The company's core operating income benefited from its investment in a consolidated trust of business purpose residential mortgage loans, which contributed approximately <unk> <unk> per share of core operating income during the fourth quarter.
Forward notwithstanding the expected continued strong economic performance of this particular investment the company expects that its contribution to the company's core operating income will be lower in the first two quarters of 'twenty one as its short duration of this asset is expected to lead to an accelerated pay down of the investment.
During the first half of the year.
The Companys book value was $6 31 per share as of December 31, as both its agency MBS and mortgage credit investment strategies experienced positive performance. This resulted in the company delivering an approximate 7% economic return during the fourth quarter, while still maintaining a conservative.
Risk profile and low leverage as of December 31, the company's overall at risk leverage ratio was two four to one with the company having significant financial flexibility.
The company continues to be committed to its stock repurchase program during the fourth quarter. The company repurchased one 5% of its outstanding common stock at an average repurchase price of $2 83 per share that contributed <unk> <unk> per share to book value.
For the year, the company repurchased 10% of its outstanding common stock that accreted 29 per share to book value.
As of December 31, the company have remaining board authorization to repurchase up to $16 2 million shares of common stock.
The company was pleased with the performance of both its agency and MBS.
Agency, MBS and mortgage credit investment portfolios during the fourth quarter as both positions benefited from spread tightening as of December 31, the company's investable capital is allocated 81% to its agency mortgage strategy.
16% to mortgage credit and 3% to MSR since January one we have allocated an additional $7 million to our mortgage servicing rights strategy, which raises the overall MSR allocation to 5% of capital and we expect that to continue to increase.
Levered agency MBS returns continue to benefit from low repo funding costs ongoing federal reserve support as well as the Steepening yield curve.
Against this backdrop, we are currently seeing available returns in the high single digits, and Levered agency MBS with an appropriate hedge position.
However, the company remains somewhat cautious about significantly increasing leverage on its allocated.
Agency mortgage capital in the current environment as a result of the federal Reserve's present support the agency mortgage market through large scale purchases agency bond prices are relatively expensive trading at a significant premium to par, including sizable pay up premiums for specified mortgage pools.
If the economy continues to demonstrate improvement any market expectation that the federal reserve could taper its holding of agency mortgages could lead to a meaningful widening of agency mortgage spreads.
Which on the other hand would provide an attractive entry point for new investments.
In the current environment the company expects to maintain a substantial capital allocation to agency MBS, while evaluating opportunities to redeploy liquidity. It holds primarily in the form of unencumbered agency MBS.
Into other investments and its target strategies that complement agency MBS, while offering at the same time better risk adjusted returns and requiring lower at risk leverage the.
The company is presently focused on particular on growing its investments in MSR related assets as well as business purpose and other residential mortgage loans. While also closely reviewing other opportunities such as single family rental and specialty finance assets that meet the company's objectives for low leverage strong return.
<unk> diversification of risk and term or non margin level financing structure.
The company continues to see compelling return opportunities in the newly created mortgage servicing rights of Fannie Mae and Freddie Mac loans at current purchase price multiples just above three times Unlevered MSR investments provide superior base returns to Levered agency MBS with potential upside from multiple.
<unk> expansion without mark to market financing risk and reduced exposure to matched hedge funding risk in.
In addition, our investment in MSR Diversifies, our investment risk as mortgage servicing rights generally have a negative return correlation to most of the other investment classes. The company owns or is evaluating including agency MBS.
We also benefit from our long term institutional knowledge and assessing prepayment risk and agency mortgages when evaluating MSR investment opportunities.
However, significant barriers to entry exists for investing in the mortgage servicing rights arena as one is required to hold specific licenses to purchase or hold msr's directly.
To invest in MSR through traditional traditional means an investor would typically need to establish or acquire a licensed residential mortgage servicer.
Which requires a significant amount of time and capital to complete as well as subjects, the investor to ongoing operational and regulatory oversight and risk.
As an alternative to the traditional pathway. The company has entered into a strategic partnership with.
With a licensed GSE approved servicer during the fourth quarter that enables the company to garner the economic return of an investment in Msr's without the company holding the requisite licenses directly.
At a high level the company is effectively renting instead of purchasing a license servicing platform.
We believe our strategic relationship is the most efficient and cost effective way for Arlington to gain exposure to mortgage servicing rights.
Under the terms of our strategic relationship the company provides capital to our partner to purchase an MSR directly and the company and turn receives all the economics of the MSR lesser fee payable to our partner.
At our option and direction, our strategic partner has the capacity to utilize leverage to potentially increase returns to us.
We completed our first MSR transaction at the end of December with an additional investment in early 2021 for a total current investment of $16 million comprised entirely of newly originated Fannie Mae loans. These MSR were purchased at an average multiple of three one times.
With an expected unlevered return of approximately 10%, while also offering potential appreciation with any retracement towards pre COVID-19 MSR multiples.
As of December 31, the company did not have outstanding repo on any of its non agency MBS.
The company sold repo funding exposure on its mortgage credit investment portfolio consists of a $32 million repo funding.
For our commercial mortgage loan with strong credit characteristics that has performed in line with expectations at its origination.
This repo facility matures in November of 2021 and has not experienced any margin calls today.
Going forward the company will continue to limit its use of margin over repo funding.
Our mortgage credit investments instead, the company will focus on financing mortgage credit investments either directly or indirectly through longer term and non margin will financing structures where possible.
The company has also made significant progress toward towards improving its cost structure for the year. The company lowered G&A expenses by 16% from the year earlier further some of the expense reduction initiatives already taken by the company will not be fully realized until the end of 'twenty one.
The company expects that by the end of 2021, it will have lowered its annual run rate of G&A expenses by over $3 5 million or almost 25% over a two year period.
Overall during the fourth quarter the company made solid progress towards its objective to complement its core agency MBS portfolio by building a series of high return non commodity investment channels, which provide multiple sources of income to raise overall returns to shareholders.
Diversify risk and offer sustainable ongoing investment flows as well as potential asset and platform upside.
In addition to its existing MBS agents.
Agency, MBS MSR and mortgage credit strategy as the company continues to evaluate other attractive specialty finance investment opportunities.
With a focus on developing investment platforms and partnerships that could potentially result in longer term enterprise value creation.
As the company deploys available capital to agency MBS and our diversified investments made through non commodity channels. We expect higher returns from these investments to provide expanded earnings power over time, which can perform them, which can form the pathway potentially for returning capital to shareholders as that.
Deployment process occurs we expect to maintain a strong financial position highlighted by low leverage high financial flexibility and the use of term financing structures, where possible, enabling the company to be opportunistic and capture attractive investment opportunities that may arise across sectors as conditions evolve.
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As well as the ongoing ability to utilize its sizable stock repurchase authority.
Thank you very much and we're happy to take questions.
Thank you at this time, we will open the floor for questions. If you would like to ask a question. Please press star followed by one on your telephone keypad questions will be taken in the order in which they are received if any time you would like from MS yourself from the question queue Press Star two.
Our first question comes from Doug Harter with Credit Suisse. Please go ahead.
Thanks, Brock, hoping you could tell us a little bit more about.
Who you're partnering with on the MSR and just.
Any sense, how we should think about whether you think.
Are you taking any counterparty risks.
Net.
You heard net masala honest with structured.
No.
Invested with a with an existing servicer.
That's had a.
Fairly lengthy history in the business.
And.
We don't have any.
Particular counterparty risk in it.
Our recourse debt.
Other recourses to the investment itself.
We received the returns value valuations in that asset can fluctuate up or down of course.
Although we think these multiples are attractive.
And we feel like we've got a.
A reliable partner.
And coincidentally.
Got some similar characteristics. Some other partnerships that have been announced to the market recently.
Great and then I guess can you just talk about.
Is it kind of your discretion for future investments in MSR that are made.
How much of that is going to kind of be on a flow basis versus kind of bulk opportunities.
Just to think about the pacing of new.
New opportunities.
Okay.
Is it our election Theres, a theres a rather constant flow Doug as you would expect of opportunities.
But what we're seeing so far is a combination of flow and bulk opportunities we've participated in both.
So we will be able to be opportunistic in that and capture what we think are the best situations.
Situations for risk return.
And we control the lever on the pace and the specific investments through that.
Through that channel, we do have the opportunity for.
Increased exposure there over time, but it is at our election.
Great I appreciate it thanks for the time to Iraq.
Thank you Doug.
Our next question comes from Trevor Cranston with JMP Securities. Please go ahead.
Hey, Thanks, good morning.
Good morning, a couple of more couple a couple more questions on the MSR strategy.
I guess first one how are you guys thinking about as you.
Deploy more capital into MSR assets.
Do you anticipate.
Replacing some of your swap hedges on the agency book.
The MSR piece growth or how do you think about that as a hedge to the agency MBS strategy.
Well to your point Trevor as you know the MSR as our natural hedge component for the agency portfolio. So over time as the scale of that MSR silo grows and then allocation growth then that will form more of a.
Per our proportion of the hedge structure and at a certain point would replace swaps.
Swaps some some amount of the swaps.
Okay got it.
And you mentioned debt.
The.
The ability to apply some leverage to the Dms.
The MSR asset in the future if you if you choose to.
Does the partner Youre working with on the.
This strategy already have access to.
Financing line for MSR is or is that something.
I would need to get your arms around supply.
It's in place.
Debt facilities in place.
Okay got it and then one last thing on that.
I think you mentioned.
There is an oversight fee associated with the strategy could you.
You just talked about.
What the fees are that are you going to be paying to the partner.
It's a it's a percentage.
As a percentage of the realized return over the life, so it'll be based on what our actual.
Experienced our actual return experience is and then it's a proportion of that debt is re entirely reasonable and consistent with market standards.
Okay great.
And then just one thing on the credit portfolio.
You mentioned.
The consolidated business purpose loans.
It's a pretty big impact on <unk> results, but it is going to decline.
The short duration of those assets are there any other opportunities you guys are currently seeing in the credit space that you think are attractive and you might look to sort of redeploy.
The BPL assets pay down.
Well I'd say as U su shortly have observed as well Trevor spreads generally a pretty tight so we are.
Intensely focused.
As I'm sure other of your.
Companies, our management teams intensely focused on identifying those circumstances, where one can gen.
Generate a bit outsized returns.
It's harder and harder to achieve in CUSIP securities So increasingly.
Loan related direct loan related opportunities, we find have been demonstrating a bit.
Better return profiles, but we.
We do see.
<unk> interesting opportunities in the <unk> space.
We have also seen occasional opportunities in the BPL space, it's gotten more expensive, but we see occasionally opportunities there and we expect to try to take advantage of those as well and then as I said I think in the interest.
In the script.
Closely evaluating single family rental which is does not mean, it's certain that we.
That we deploy capital there, but we are very closely evaluating that as that appears to have some attractive return profiles versus the risk parameters as well.
Got it okay I appreciate the comments thank you.
Next we will go to Jason Stewart from Jones trading. Please go ahead.
One more thing just real quick before you go Jason and responsive Travers question. One other area that we have examined that we find to be quite compelling or some solar residential related loans.
And we've spent a good deal of time evaluating closely evaluating those.
We expect that there is a reasonable chance that over the course of 'twenty one.
We may very well deploy capital there those among many of the other opportunities we see carry with them quite attractive returns.
Okay, Alright, Thanks, Trevor go ahead.
Along the same same lines rock when you're describing some of the strategies that they all seem sort of in line with that remaining a REIT, but if you pull back up and look at the status of the company and really one of the larger assets and Levered Agency, maybe you could talk about the future of that given your comments around the return profile. These other businesses.
How you see the company structured longer term.
Well as I said in the script Jason.
We're seeking to accomplish is to complement that agency portfolio with to provide a level of diversification of risk and overall higher returns in an environment where agency prices are relatively expensive.
There are cheaper today than they were a week ago, but.
But they're relatively expensive relative to the characteristics and the returns and therefore.
When when we're envisioning high single digits returns there with meaningful leverage profile, we're seeking alternatives that can generate those are higher returns with without that level of margin level risk profile.
And provide for the opportunity to use term or.
Or structured finance elements to them and so what we envision is that that'll be a ongoing dynamic process certainly in the near term, we would envision that the agency portfolio would form the bulk of that allocation.
And it will take us time to deploy.
The capital into these other arenas, we've made a good level of progress with the deployment two <unk> and certain of our other mortgage credit investments over the back half of 'twenty, which did exceptionally well we continue to mine those silos for opportunity we find them occasionally although.
As I have said theyre fairly expensive and the new ones whether that is <unk>.
<unk>, which we find to be quite attractive relative to other asset classes right now.
We expect to grow that and provide for an along with.
Potentially single family rental or maybe solar opportunities as they come to us.
We will have more a more balanced approach in which agencies.
Agency is will.
Presumably comprise a substantial proportion.
Of the capital allocation, but will have a balanced waiting and other elements debt raise the overall return profile.
At least during the period in which agency returns are at this level if they were to.
Cheapen up meaningfully then that would allow us through a dynamic process to reallocate capital back to agencies if the returns.
And very large scale, if the returns elevate to a level based on the.
Price of the asset and the change any change that we may experience in CPR profiles.
And the shape of the curve.
If those returns elevate enough then we will be wide open to the idea of.
Moving capital back in that direction and more scale.
Our goal is to build non commodity channels with higher returns.
Is that ideally have a platform capability, which gives sustainable ongoing flows.
<unk>.
And we may find those that provide us.
A franchise or platform upside opportunity we are in the process of evaluating a couple of those right at the moment, which could be which could be quite compelling. So we're making room for those kinds of opportunities and to complement the agency.
Return profile.
Okay and all of these strategies have pretty strong cash flow components to it. So if you remain a REIT I would assume you have no distribution requirement for 2021.
When you pull all this together what's your what's your big picture thought on when the dividend becomes more of a part of the conversation.
Well as I've said in the script thanks, Jason.
As I said in the script.
I think we are.
The ongoing deployment of the.
Available capital embedded in the existing.
Agency portfolio.
Can be reallocated to those that process is underway that will take some time and.
As that deployment goes on we would expect the earnings power of the company.
Two to elevate and as that elevation occurs and that will form the foundation for returning capital to shareholders in its various forms including <unk>.
Including distributions through dividends to shareholders.
Okay, one more and then ill jump out on the MSI.
Yes, Sir.
Now I could please.
On the MSR you gave us a lot of great detail. The return profile is a little bit higher net.
I think the typical market sees from MSR is today and I assume that's because of the strategic punished debt of the relationship could you talk through sort of what that relationship brings in terms of economics, and then maybe hit on your recapture assumptions or what sort of the big assumptions arent getting to that double digit return profile are.
Well I think the returns that I alluded to in my conversation.
We're the returns I alluded to in the conversation we're live.
These are literally investments that we've made in the last few days.
So.
So those we feel like those <unk>.
Neighborhood of 10 Unlevered returns.
Multiples just above three.
Continue to be.
Available now does everyone hit the 10, Mark I don't know that to some there may be somewhat.
Somewhat above somewhat below but the key is that these are all on new production loans.
Right that have been originated here at nearly the bottom.
<unk>.
Of rate levels of wax.
And also are accompanied by a lower multiple than historical multiples on msr's.
So I think I suspect you may hear people quote.
<unk> from just today at new production at just below 10 to maybe just above 10, and I think that's what we're what we're seeing.
You also probably have companies that you are.
That you cover are familiar with and have seasoned.
Portfolios that may have multiples closer to four or potentially more.
And so we think that here at these multiples.
We're reasonably comfortable with the speed assumptions.
And at the time for the time being we are unlevered and that structure.
And we do have the ability to lever up to some degree.
Although we will be careful and cautious about that we do have the ability to lever that up to.
To maintain.
A very attractive return profile there.
Great. Thank you.
Yeah.
Yeah.
Thank you. Our next question comes from Christopher Nolan with Ladenburg Thalmann. Please go ahead.
Right, Chris Hey, how are you guys doing.
Mark what do you think the contribution from net V I E.
Short term investment will be in the first quarter.
I'll leave that to rich.
Yes, Chris this is bret.
You saw in our script.
Q4, investor deck and contributed about <unk> <unk> for that for the fourth quarter because of the short duration of those assets.
These are residential and fix and flip loans that have short maturities and they pay off quickly.
No we're expecting it to be significantly pay down entire structure by by the middle of the year.
And that's happening sequentially over that time period.
So we don't have it.
Difficult to predict because it's.
Based upon the underlying performance of the loans in terms of credit quality and continued to remain strong.
All that plays out.
But our expectation is that it will be somewhere in the low single digit in terms of.
Per cent per share to two core operating income.
For the from the first quarter sales.
We had <unk> from FERC in the fourth quarter said I expect something much towards the lower single digits in the first quarter its contribution to our cooperating income.
Great. Thank you.
Also in terms of the fix and flip I mean.
That has pretty rich yields and is that something that you guys are actively looking to expand into.
Well, we've made we've made a series of investments there so far Chris and we've actually we've built a good deal of intellectual property.
Allied ourselves with a very very sophisticated.
Partner.
We work with in that arena typically.
Although we have access to more than one.
So far with one in particular that is extremely sophisticated and we've been able to build off of.
Fair amount of intellectual property.
Round debt arena, and so we absolutely would be interested in expanding that.
In situations, where we find that the pricing is acceptable.
We've we've we spent a little bit tighter lately alongside other.
Tighter spread investment circumstances, as you well know but.
We have come across circumstances, even as recently as the last week or two that.
It could be interesting Ken can conform interesting opportunities. So we continue to be focused on that and expect that we will in fact.
Have more business purpose loan opportunities.
Then.
Selected mortgage credit opportunities as well as I said before that half.
A bit outsized returns relative to.
Relative to their risks that we see each day in the in the broader markets.
Great and final question rock the move into Msr's.
<unk>.
And given.
Your comments in terms of concerned about rising Prepays I mean, it doesn't the addition of msr's or compound your assets.
Exposure to Prepays.
Well there there really.
Sort of complementary.
Two agencies in a way.
Certainly is.
To the extent that rates elevate.
And speeds slow obviously, that's very strong.
A positive factor for MSR.
And we wouldn't be surprised.
See potential expansion.
In multiples.
As that happens.
We've observed as I'm sure you guys have as well some expansion in multiple.
Over the last.
Over the last 25 basis point move in rates.
And.
Sure.
And so we wouldn't be surprised if that process.
Ken.
Can continue as to the extent that rates elevate further.
Obviously.
So in that way it sort of complements and naturally complements sort of the agency book.
Book and to the earlier comment will will provide.
Replace and provide some portion of the swap duration hedging effect against the agency portfolio.
Very nicely.
Together and I'd say, our assumptions are that we're buying in line with.
Market speed assumptions for those assets or we're assuming higher speeds.
So we've sort of tried to protect ourselves a bit on the downside and returns to some extent by.
Sort of raising our speed assessments slightly.
Slightly above market.
Great. Thanks, Scott.
Thank you and Mr. <unk> there are no additional questions at this time.
Great well, thank you to everyone for your time and your thoughts and if you have further questions. Please.
Please don't hesitate to call. Thank you.
Thank you ladies and gentlemen. This concludes today's conference you may now disconnect.
Yeah.
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Okay.
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