Q1 2021 Arlington Asset Investment Corp Earnings Call

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Good morning, I'd like to welcome everyone to the Arlington Aster first quarter 2021 earnings call.

Please be aware of the each of your lines is in a listen only mode.

I think the accompanying the remarks, we will open the floor for questions.

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For two.

I would now like to turn the conference over to Rich Carlton Mr. Collins of Bank you may begin.

Thank you very much and good morning.

The rich content, Chief financial officer of Arlington asset.

Before we begin this mornings call I would like to remind everyone that the statements concerning future financial or business performance market conditions business strategies for expectations.

Any other guidance on present or future periods.

Institute for looking statements that are subject to a number of factors risks and uncertainties that might cause actual results to differ materially from the state of the 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 the result of possible events or 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 SEC from time to time, which are available for.

The company and from the SEC and you should read and understand these risks when evaluating any forward looking statements I would now like to turn the call over to rock <unk> for his remarks.

Thank you rich good afternoon, and welcome to the first quarter of 2021 earnings call for Arlington asset also joining us on the call today is John Murray our portfolio manager during the first quarter of risk assets continue to rise a bit of progressing global economic recovery supported by government monetary and fiscal <unk>.

Stimulus policies broader vaccine rollout of efforts in growing expectations of a full economic reopening with.

With the increased positive outlook, the overriding long term economic theme for the quarter was inflation risk.

In response to the long term interest rates rapidly rose with the tenure of U S treasury rate, increasing over 80 basis points during the first quarter, leading to a significant steepening of the yield curve at short interest rates remain the anchored at the historical low levels.

The short rise the sharp rise in the long end of the Treasury curve led to an extension of mortgage durations, particularly lower coupon agency MBS for.

Performance of mortgage servicing rights was strong during the first quarter as prepayment speed expectations decline with the rise of mortgage rates.

Residential mortgage credit spreads were relatively flat during the quarter, while home price depreciation continued its strong annual growth.

The company's long term investment strategy is to construct an investment portfolio with multiple sources of income, which complement our agency MBS portfolio the.

<unk> risk and improve the level of and reliability of returns overtime. The company expects the complement its allocation of capital of agency mortgages by deploying portions of its liquidity currently in the form of <unk>.

On encumbered agency MBS into it the other targeted investment strategies, including mortgage servicing rights mortgage credit and other asset classes.

We expect the can maintain a strong stable in the liquid financial position by keeping leverage low and financial flexibility high while utilizing term non margin financing structures were 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 compound compounding value creation opportunities that layer on top of the current investment returns embedded in the company's investments.

During the first quarter of the company made solid progress towards these goals by reallocating capital in the MSR related investments.

As of March 31 of the company's Investable capital was allocated 75% to its agency mortgage strategy, 12% of mortgage servicing rights and 13% of mortgage credit.

Newly created mortgage servicing rights of Fannie Mae and Freddie Mac loans currently offer attractive return opportunities.

The purchase price multiples of just above four times Unlevered MSR investments offer comparable base returns the Levered agency MBS with potential upside from multiple expansion positive correlation of duration extension no mark to market financing risk and no.

Exposure to matched hedge funding risk.

Significant barriers to entry exist for investing in mortgage servicing rights as an investor is required the whole specific licenses the purchase or hold the MSR directly.

To invest in MSR through traditional traditional means an investor would typically need to establish or acquire of licensed residential mortgage servicer, which requires a significant amount of time and capital to complete as well as subject to the investor the ongoing operational and regulatory oversight of risk.

On our prior earnings call, we highlighted that the company has established a strategic relationship with of licensed GSE approved servicer that enables the company. The garner the economic return of an investment in mortgage servicing rights for that.

All of holding the requisite license directly.

Under the terms of our partnership the company provides capital to our partner to purchase the MSR is directly.

And the company and turn receives all of the economics of the MSR.

Less of fee payable to our partner.

We believe this efficient cost effective cost effective and lower risk channel for investing in the economics of mortgage servicing rights differentiates Arlington.

The date, our economic thesis for allocating capital for the mortgage servicing rights has produced positive results as our MSR related asset investment portfolio generated outsize returns above expectations during the quarter.

MSR cash flows performed as expected and the portfolio experienced significant multiple expansion from approximately three times to modestly above four times.

The company has not utilized any leverage on its MSR investment portfolio to date, but at our option and direction. Our partner has the capacity to add leverage to increase potential returns the.

The company's MSR investment portfolio grew to $36 million or.

For 12% of Investable capital as of quarter end and subsequent to March 31, we have invested an additional $31 million in MSR related assets, increasing our investable capital allocation to over 20% today, representing approximately $6 4 billion of unpaid principal balance.

Yeah.

Turning to Levered agency MBS returns there continue to benefit from low repo funding costs ongoing federal reserve support and Steepening yield curve, although the rise in long term interest rates and extension of mortgage duration.

Increased hedging costs during the quarter.

Against this backdrop, we are currently seeing available returns in the high single digits, and Levered agency MBS with an appropriate hedge position.

However of the economy continues to demonstrate improvement in inflation concerns continue to escalate market expectation that the federal reserve May taper. Its holdings of agency mortgage could lead to a widening of agency mortgage spreads.

With mortgage spreads currently at multiyear types the.

The company remains cautious about significantly increasing the leverage on its allocated the agency mortgage capital.

Taken in combination complementing the Levered agency portfolio with Msr's decreases overall risks, while increasing Roe.

Msr's tend to increase in value as mortgage rates rise of more specifically when durations on agency MBS extend.

This increase in value, resulting from mortgage extension typically occurs when Mitch mismatches.

<unk> Levered agency MBS and hedges are highest.

Furthermore, msr's are of positive carry hedge for Levered agency securities, replacing negative carry swaps with positive carry msr's turns of the largest drag on Levered agency MBS returns in the current environment into a carry positive.

More specifically for every $10 million in the MSR as we aggregate, we can invest approximately $5 million of capital and leverage the agency securities without the need for a long dated hedge.

Said another way.

Set against the backdrop of our agency MBS portfolio of balance.

Of approximately $615 million at March 31.

The MSR portfolio, we now hold.

With unpaid principal balance of $6 $4.067 billion of capital invested.

And of WAC of 296%.

Would have eliminated the need for approximately $120 million of long dated hedges at that time.

Which would have added approximately 200 of 400 basis points.

Of Aro.

To fully Levered agency MBS returns.

Boosting them into the double digits from the high single digits and improving the overall risk profile in that portfolio of combined.

In the current environment the company expects the maintain a substantial capital allocation to agency MBS, while evaluating opportunities.

To redeploy the liquidity it holds primarily in the form of unencumbered agency MBS into other investments and its targeted strategies overtime that complement agency MBS, while offering better risk adjusted returns and requiring lower at risk leverage the <unk>.

The company is presently focused in particular on continuing to invest in the MSR related assets as.

As well as mortgage credit opportunities, which offer risk adjusted returns in excess of agency MBS.

While also closely evaluating opportunities in the other financial asset classes, including those that may not be mortgage or real estate related that meet the company's objectives for low leverage strong returns diversification of risk and term or non marginal financing structures.

For the first quarter Arlington's agency mortgage investment portfolio with the concentration in lower coupon securities underperformed as asset prices decline due to increased rate volatility and asset duration of extending in response to the sharp rise in long term interest rates.

The company was net long duration and its combined the agency MBS in the hedge portfolio at year end, while the MSR portfolio was not yet able to be scaled at the beginning of the year to fully offset agency MBS price decline.

The company added significantly to its hedge and the MSR positions as interest rates first began the arise which served to mitigate the asset price declines experienced during the quarter.

The underperformance of the Companys agency MBS and hedge portfolio. During the first quarter was partially offset by a very strong performance and the company's MSR related assets as well as its mortgage credit investments due to strength strengthening credit metrics in that portfolio.

These combined investment portfolio performance results led the company to report book value of $6 12 per.

Her share as of March 31.

The decline of 3% from the prior quarter end.

As of March as of April 30th the.

The company's book value per share increased approximately 1% since quarter end.

The company continue to operate with low leverage and significant financial flexibility with its overall at risk leverage ratio standing at one four to one as of March 31 of the of.

The decline of one turn from you.

Year end.

For the first quarter of the company reported a GAAP net loss of <unk> 20 per share and core operating income of <unk> <unk> per share as we highlighted during our prior quarter earnings call. Despite the strong credit performance of of consolidated trust of residential business purpose loans, we anticipated its contribution to our first quarter core.

The income would decline due to the short duration and accelerated pay down of that investment.

Although its copper contribution to core operating income was lower this quarter. The companys investment in this consolidated trust <unk>.

Experienced a particularly strong economic return of 9% for the first quarter.

As its credit performance continued to exceed our initial expectations.

The company did not declare a dividend on its common stock for the first quarter. The company's board of directors will continue to evaluate the payment of quarterly dividends on its common stock based on multiple factors, which including current earnings results overall market conditions liquidity needs return opportunities on investments.

And REIT distribution requirements.

With regard to its REIT requirements. The company does have the flexibility to utilize its tax loss carryforwards to reduce its taxable income in the annual distribution requirements. The.

The company will also look to continue to return capital to shareholders by Opportunistically repurchasing shares.

Of its common stock at accretive prices.

The company continues to have a large remaining authorization from its board to repurchase shares of its common stock.

Overall the company is very encouraged by the solid progress. It has made to date and the transition towards its long term goals and is optimistic about its prospects going forward the <unk>.

He took positive steps during the first quarter towards its objective of complementing its agency MBS portfolio with high return non commodity investment channels, which provide diversification of risks multiple income sources to raise overall returns to shareholders.

And offer sustainable ongoing investment flow in addition to its existing MBS.

<unk> and mortgage credit strategy as the company continues to evaluate opportunities in other attractive financial aid class asset classes, where the focus on developing investment platforms and strategic partnerships that could potentially result in long term enterprise value creation.

As the company deploys available capital to MSR 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 form the potential pathway for returning capital to shareholders.

Net deployment process occurs we expect to maintain a strong financial position highlighted by low leverage high financial flexibility in the use of term financing structures, where possible, enabling the company to be opportunistic.

And capture attractive investment opportunities that may arise across sectors of the economic conditions of all as well as the ongoing ability to utilize its sizable stock repurchase authority.

Operator, I'd now like to open the call for questions.

Thank you.

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 quest.

Question from taken in the order in which they are received.

So any time you would like to remove yourself from the question queue. Please press star two.

We'll take our first question from Trevor Cranston with JMP Securities.

Hi, Thanks.

A couple of questions on the MSR investments.

I guess first as you think about deploying more capital into that asset class.

And you know the sort of benefits it has relative to an agency portfolio.

How are you guys thinking about sort of of target.

For capital allocation of and how much of your capital you could potentially.

Alex the allocate towards MSR, it's over the course of the year.

Afternoon Trevor.

So today with $67 million of capital invested there.

We have not yet utilized the financing facilities that are available to us.

And those financing facilities enable us to borrow.

Not quite but almost on a one to one basis.

I don't think we envision that we would.

The lever that significantly.

But I think we could see our way to using something along the lines of half of that leverage amount.

Which on the existing capital allocation could take us up to the neighborhood of not quite a $100 million of total value invested in msr's.

So in the in the near term that sort of feels like our horizon, our natural horizon.

Depending on markets.

Multiple.

Primary rate and other factors, we we would we would consider going beyond that but our near term horizon is probably somewhere between here and of $100 million of total investment, which would mean a modest.

Any incremental.

Allocation of capital now.

That may.

That may change over time, but in the reasonable near term timeframe, that's sort of how we think about it.

Okay got it.

And then in terms of the <unk>.

Asset yield on MSR.

The number you reported on slide 10.

Excuse me.

You know pretty attractive relative to a lot of other <unk>.

Fixed income assets in the market right now.

I was curious if.

Is that nine plus percent yield.

Is that something that particularly benefited from buying low coupons prior to the big increase in mortgage rates.

And I was also curious if you could just comment on where you would expect economic yields on new MSR purchases to date.

Sure. So as you saw last quarter, we had initiated the partnership.

During the course of the fourth quarter I think probably in the latter part of the fourth quarter and we had at.

That layered in at that time, you know 10 or $15 million or something like that of Msr's.

We added another significant amount of early in the first quarter.

So we sort of got the benefit of investing in those at lower multiples say in the neighborhood of three ish.

Maybe a little below a little above between those two baskets.

A little bit below or a little above three.

And so we benefited during the quarter for.

For multiple expansion as I said in the script and to your question.

Yields were naturally higher there because of the lower multiple that we were paying on those.

Msr's today.

As I said sort of a I alluded to in the script, we look at multiples in the neighborhood of for.

And at that level, you're probably closer to something like an eight.

Maybe an eight and change.

Something like that would be a.

Would be a reasonable level on a bulk purchase and maybe a little higher on a flow.

We would expect to be in.

<unk>, a little bit more going forward than we have been to date in the flow market.

Where those even at these multiples look like they are closer to closer to nine.

And so.

We feel like that eight to nine range today, depending on volcker flow was probably.

A fair range for Unlevered yield in those assets newly placed in the portfolio from here forward.

Okay got it.

And then in terms of the year interest rate positioning of the balance sheet portfolio.

Looking at slide nine.

Seems like you have a fairly large amount of.

The long duration swaps relative to the agency book.

In addition, you obviously of the MSR is kind of continued to add to those.

Did you say what kind of what your overall net duration is or your exposure to kind of changes in the long end of the yield curve.

And also maybe comment on.

Whether or not you of any made any changes to the swap book.

In the second quarter as you continued to play more of a sort of.

Yeah, Great question Trevor Great question.

Well placed.

The.

At that time, we had not yet closed on a block of <unk>.

<unk> that we've been able to put in place.

April.

And so no surprise to your question.

Thats provided an opportunity to sort of shift our footprint a bit from a duration perspective.

No.

You'll see in the in the chart there that we had a bit of a.

A negative duration bias.

The negative duration bias at that time.

And.

And and Thats left now.

That's closer that's closer to flat I'd say still slightly negative.

Meaningfully less negative duration than was the case at that time, but still between zero and one.

Also keep in mind that at the time, you see those charts ne.

The neighborhood of $200 million of those were short swaps two to three year.

And.

So that's worth keeping in mind and then the last thing is.

We've actually scale of the agency balance up a bit more.

Since quarter end with the benefit of that MSR block in place that closed in April. So we've got a bit larger agency book, We've obviously got a larger MSR footprint than we did at quarter end and the net duration of that.

The net duration of effect of all of that in combination with some modest shifts on the hedging.

The hedging side leaves us too.

Less negative duration more between zero and one today than was the case then.

And Trevor this okay I think if you didnt see on slide 19, we have the the.

The calculation at quarter end.

Of our duration gap in the interest rate sensitivity the.

The rate shock sensitivity to the portfolio as well.

Yeah.

Okay.

So thanks for pointing that out.

So okay the field trip.

Without going here Trevor.

Clarify it.

For more of that would be helpful. There.

No that did answer the question.

Great I appreciate the color. Thank you guys you bet.

Well take our next question from Christopher Nolan with Landenberger Feldman.

Rock in the second quarter have you guys.

Increase your capital allocation at all to mortgage credit.

The slightly.

I think we we have begun to see more interesting opportunities Chris.

In mortgage credit.

In the second quarter sort of very late in the first quarter into the second quarter.

So we've added a bit to that portfolio since the end of the quarter.

And we are looking more closely at those.

Net Roe.

The edged back up into the double digits from their tights, which would have been you know.

High single digits, some returns on equity and credit even got to the point, where they were not that far above five.

That has now loosened up and given us some new opportunities we were selling into those tight.

As you saw our balances come down in the first quarter second quarter, we've actually been able to move that up a little bit and without predicting that we will of wood.

<unk> surprise me, if we were able to add some incremental volume there to the mortgage credit portfolio in the quarter given the improvement in ROE into the double digits.

And as you look at the second half of the year.

Where.

Conceptually are you thinking you'd like the capital allocation.

<unk> to look like from where it is now.

Well, it's a good question it'll depend on it will depend on relative.

The relative risk adjusted return opportunities so.

As we've said now for a couple of quarters, we have been evaluating a number of opportunities across.

Mortgage related and some non mortgage related asset classes, we've made some progress there.

I think I may have alluded in the last quarter, we were close on another win in the end it didn't work out but we have.

Several other initiatives that we are in process of that we're making solid progress on we'd be hopeful that we will have.

Positive things to say about the this during the course of this quarter at our next quarter.

Release, but we certainly can't guarantee that but we are encouraged by progress in those things I think it will the capital allocation mix will be a byproduct of the progress that we make in some of these alternative higher return.

Risk diversifying.

Asset opportunities that we are investigating now for now.

Two of my answer the Travers question earlier, I think you'll see us incrementally dial up the capital allocation to MSR.

I don't expect that debt in this particular quarter would be a really.

The enormously substantial move up in the allocation of the MSR of relative to.

Relative to the agencies, because we would most likely use some leverage in that portfolio is our first lever.

But that will depend on where.

The multiples are in wax on MSR versus Levered returns in agency.

For the extent that some of these others develop then.

In the quarter of the course of the second and the third quarter.

Through the year, then we would expect to see this debt allocation rise above of total 20 of 25%, which was where it was at the end of the quarter.

The two non agency MBS capital so.

Moving agency capital probably in that in that case closer to 50% from the 75 per day and in the process of raising returns and lowering leverage.

Our final question is for the mortgages underlying your msr's.

Do you seek out of particular profile of the loan or borrower.

So what is that please.

Well you can see from what.

What I said in the script.

With a 296 WAC, we're trying to be quite focused.

We're trying to be quite focused on keeping the lid on the WAC and protecting against prepayment speed escalation as best we can in that process.

We're probably sitting here today at a little net in the neighborhood of 50 basis points I think above are.

Our lows are historic lows in the primary rate.

And we feel like at $2 96, WAC, we're reasonably well protected.

And the.

And we will continue to try to focus on keeping those wax low and are ongoing.

MSR flow and bulk.

<unk> in the meantime, we're very very focused on the nature of the originator.

The pattern of their prepayment experience across their assets, which were also able to follow through our agency mortgage investing.

So we're familiar with these originators pretty intimately familiar with them and we can.

We're aligning our MSR purchase investments with the.

With our knowledge from the agency side from a prepayment perspective, and we're very focused on the recapture capability of these.

Of these originators and servicers to to recapture of the Prepays. So.

That's our focus we've had some success here initially.

We feel like we'll continue to try to keep the discipline that we've begun as we've.

We entered into this partnership and begun to scale it to some level of critical size relative to our total capital mix.

Great. Thank you.

Well take our next question from Josh Bolton with Credit Suisse.

Hey, thanks.

Rock you mentioned in your prepared remarks, the share repurchase authorization that you guys have curious.

How are you thinking about the tradeoff between deploying capital into one of your target assets versus the return you would get by repurchasing shares.

Sure so.

Naturally Josh good question naturally one that we're focused on every single day.

As we evaluate our alternatives I think.

What the variables are I think pretty well and that it is the magnitude of return on our opportunities.

Versus the accretion that we can generate from repurchasing the stock which is on the one hand substantial.

But on the other hand repurchasing the stock.

And reducing the capital base does have other effects as you know so thats an ongoing calculation you've seen us be quite aggressive in the past both corporately and personally.

As folks saw in addition to buying back.

A healthy chunk of the stock last year at attractive prices and doing it accretively doubled my own personal stake in the company.

And other management members have as well.

So we continue to view the stock.

As you know very positively from an investment perspective.

And our dynamic of process for evaluating returns against that.

The sets up in the context, where we're also judging it of best against market volatility in the first quarter, we did buy stock not as much as we had in prior periods.

And part of the reason for that was the level of volatility in markets as well as the.

The very compelling nature of the core.

Quite exceptional return opportunity, we felt we were facing in the MSR in particular.

We are of value, we continue to evaluate that all the time.

We view of the stock.

Is very attractive today from a from an investment and repurchase perspective.

And when our Windows open up.

Kind of assume that we will be very closely assessing that question on a day by day basis.

Great. Thanks for the construct.

Yeah.

We'll take our next question from Jason Stewart with Jones trading.

Great. Thank you. Thanks for all of the color I was hoping you could elaborate a little bit more on your comment about non mortgage non real estate opportunities.

How close we are to that and sort of what realm of parameters youre looking at there. Thanks.

So good.

Good question, Jason I think.

I think we've alluded to this in the past.

Debt within the company, we have a range of intellectual property and expertise based on our collective many decades.

In financial asset classes, particularly related to.

The housing and other credit, but also in other areas and so we evaluate those opportunistically on the basis of.

They're sort of proprietary in nature.

And there and our ability to create a sort of partnership.

Or sort of strategic type of relationship there, where we can generate not only of solid flow of high return.

Off asset opportunities, but also compounding opportunity and value creation through.

Through upside compounding into true through upside value of appreciation and so those are part of the metrics I'd say.

We're making good we're making good progress on some of those we don't have anything further to say about it right at the moment, but we're hopeful that during the second quarter. We may have the have the ability to speak more about that.

Sometime between now and our next release or at our next release.

Okay. Thanks I appreciate it all my other questions were already tackled. Thank you.

Mr. Tong from there are no more questions at this time.

Well. Thank you everyone very much we appreciate your time and.

Happy to help offline.

If that's helpful feel free to give us the call. Thank you.

This concludes today's call. Thank you for your participation you may now disconnect.

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