Q2 2019 Earnings Call

All participants will be in listen only mode. So you need assistance. Please signal a conference specialist by pressing the star key followed by zero. After todays presentation, there will be an opportunity tax questions to ask a question you May Press Star then one on your Touchtone phone to withdraw your question. Please press Star then too.

Please note that this event is being recorded I would now like to turn the conference over to Lindsey Crabbe. Please go ahead.

Good morning. Thank you for attending Capstead second quarter earnings Conference call. The second quarter earnings release issued yesterday July 24th 2019, and posted on our website at Www Dot Dot dot com under the Investor Relations tab.

The link to this webcast is also in the Investor Relations section of our website an archive of this webcast and a replay of this call will be available through October 20, Threerd 2019 details for the replay are included in yesterday's release with me today are <unk>, President and Chief Executive Officer, Robert Spears, Executive Vice President and Chief Investment Officer, and land Phillips Senior Vice President and Chief Financial Officer.

Before we get started I want to remind you that today's comments could be considered forward looking statements pursuant to the safe Harbor provisions of the private Securities Litigation Reform Act 90, 95 and are based on certain assumptions and expectations of management for a detailed list of all the risk factors associated with our business. Please refer to our filings with the SEC, which are available on our website.

The information contained in this call is current only at the date of this call July 25, 2019, the company assumes no obligation to update any statements, including any forward looking statements made during this call with that I will turn it over to Phil.

Thank you Andy.

After a few brief remarks, Lance I'll give a recap of the quarter.

The call up for questions.

Our core earnings held up well this quarter in the face of significant market volatility.

As the market Recalibrating from expecting 125 basis point fed rate cut to now expecting as much as 75 basis points in cuts this year.

And another 25 basis points or so 20 twond.

Was the second consecutive 12 cents quarterly earnings and Brian We increased our common dividend by 50% or 12 cents per share this quarter.

This reflects our belief that we can produce strong risk adjusted returns. This year and then the next regardless lymphocyte it reduces the fed funds rate at the pace, we anticipated by the market.

Or takes more than a one and done study at its meeting next week.

On the one hand should the fed reduced the fed funds rate a number of times as expected by the market.

We will benefit significantly considering that our seven and a half a billion dollars in swap balances at quarter end, representing 70% of our outstanding repo balances with another one in a quarter billion of the swaps maturing by year end.

This will leave us with plenty of room for our borrowing cost and benefit from rate.

Resulting lower borrowing costs will help insulate earnings from any effects of higher mortgage prepayment activity spurred by lower prevailing mortgage rates.

On the other hand should the fed not reduce the fed funds rate as much as expected, we remain well hedged at a reasonable cost having effectively planning.

Great cause through the Liberal use two and three year swaps with lower fixed pay rates relative to unhedged repo rates.

This has improved our net interest margins, while helping to insulate us from a more hawkish Fred.

Additionally, in this scenario mortgage prepayment pressures should subside.

With the market Recalibrating to expect higher rates.

A negative arc of our hedging activities is a good lost value on our swap book on a mark to market basis with a slight decline in great.

This occurred because many of these positions were put on prior to these declines.

And agency MBS pricing underperform due largely to rising expectations for high higher mortgage prepayment.

Since quarter end book value has been relatively stable.

These negative marks will dissipate over the terms of the swaps to the benefit of book value.

And should the fed disappoint the market by not reducing the fed funds rate as much as expected.

Relations could improve more rapidly.

With that I'll turn the call over to Lance.

Thank you Phil.

We incurred a GAAP net loss of 63.5 million this quarter or 80 cents per diluted common share.

Our core earnings were $14.8 million or 12 cents per diluted common share.

The difference between our GAAP net loss in core earnings primarily reflects realized and unrealized valuation losses on our swap portfolio as Phil described.

As well as certain other amounts excluded from our core earnings metric. We include a reconciliation of these differences on page eight of our press release.

Portfolio yields averaged 2.83% during the quarter, an increase of seven basis points from the 2.75, we reported in the first quarter.

Yields directly benefited from higher cash yields on acquisition as rates on the underlying mortgage loans in our portfolio will reset higher.

While absorbing the impact of higher mortgage prepayment levels.

Our portfolio related borrowing for long.

Increased 12 basis points over the prior quarter.

This increase was primarily due to higher hedging cost interest rate swaps with lower fixed rate Richard new swaps were entered into a higher rate and variable rate swap receipts were negatively impacted by declines in three month LIBOR.

On his borrowing rates were relatively unchanged from the previous quarter.

Book value decreased 50 cents per share during the second quarter $88 or 93 cents per common share.

The decrease reflects a dollar five declines associated with our hedging activities that was only partially offset by a 55% increase in portfolio related pricing changes.

With that we will open the call up to questions.

We will now begin the question and answer session.

To actually a question you May press Star then one on your Touchtone phone. If you are using a speakerphone. Please pick up your handset before pressing the keys to withdraw your question. Please press Star then two at this time, we will pause momentarily to assemble our roster.

[noise].

The first question comes from Eric Hagen of KBW. Please go ahead.

Thanks, Good morning, two questions on prepayment speeds number one when do you expect speeds to slow.

And number two the slowdown that you're expecting which corresponds to the amount of premium amortization that you're currently booking what is that prepayment speed expectation.

Thank you.

So prepays are going to remain elevated this summer and then that will start to recede.

In the fourth quarter, we assume.

And.

Any amount of.

Decline would depend upon how aggressive the fed is in cutting rates.

And and then we would expect a.

Some moderation next year.

Okay, but we don't actually make a disclosure that of what our.

Estimated prepayments speed for the future life of our portfolio I know some guys do.

But we have not made that disclosure today.

Okay I can I can appreciate that maybe an exact number isn't something that you want to provide but.

Yeah, the the portfolio paid down at 26, CPR in the second quarter that expectation or is that something.

In the low Twentys is in the high teens is it.

In the mid Twentys I mean, there there has to be a range that you can sort of guide us too. Thank you.

Well I think their arm speeds generically if you look at where we are right now in the in the mid Twentys as Phil alluded to earlier I think that.

Seasonal factors will kick that number up somewhat and the.

Third quarter before declining in the fourth.

Right now you've got a.

An interesting time in the arm market, where you have.

Longer reset securities that were originated in the last year or two.

Where.

Speed assumptions may have gone from.

18 to 25 generically it at the same token you have very seasoned arm securities that are resetting down now and estimated lives speeds have gone from the mid twentys to the high teens, so you're starting to have convergence, where newer issue longer reset paper is ramping up at the same time very seasoned bonds light to expectations are going down.

So.

The take all that in context, I would think you know that the natural progression would be from.

Mid twentys to upper Twentys back down the lower Twentys.

And then over time, depending upon what rates do I think it probably settle then in aggregate somewhere.

Low twentys to 20, CPR something like that I think that would be a big pick up projected ramp of arm speed than in the entire market I think that's kind of what you'd be looking at.

Okay. Okay. So we should figure that they'll go back to the maybe low twentys.

Overtime, but I want to hammer in kind of or focus in a little on the on the timing right because since arms are such short duration securities and you're presumably you know booking at higher yield today with the expectation that speeds will eventually slow into that call. It low twentys.

Range.

Then after how much time or at what point would you be required to take you know what is effectively a catch up charge if the if the slowdown that you're expecting doesn't actually materialize.

Well that's that.

I don't know that we can really answer that question.

Whether it catch up charge would actually be required we we look at our lives speeds.

We keep an eye on that all the time and we'll just have as we need to.

And.

I wouldn't necessarily.

Anticipate that we would have a sharp.

Change in speed required.

While conservative with our speeds we've.

We just.

I know the concern is that amortization is a little lower this quarter relative to the pickup in.

Speeds, but as we discussed last quarter, we we've been working to improve our estimation process.

[noise] for prepayments to lessen the impact of cyclicality and seasonality.

And we have a large diverse portfolio of arms and they're they're doing different things to different cohorts.

Premium levels on recent acquisitions.

Average outstanding balances are also quite a bit lower at this time.

And then also leads to lower amortization costs.

Right I understand that but I guess I'm, just trying to understand like the timing around.

Actually realizing you know what the effective amortization was on the bond relative to your expectations.

And when that when that true up needs to take place.

It is happening every quarter.

So I I don't.

I don't get the question.

Okay.

Eric The one thing I think I might say, we do book.

The actual amount rules through our core earnings we do not make an adjustment.

On premium amortization or aggressive so every premium dollar we spend.

Goes eventually come through timing on core earnings as the bond either is paid for their prepaid or through schedule.

So I wouldn't we wouldn't expect that.

The catch up like you're describing I know others.

Hi, Josh that patch of plus or minus on their core earnings, but we have traditionally been.

And continue to be conservative with that would just whatever dollar we spend on even on a premium will be amortized through core earnings.

Okay, Yeah, maybe we can follow up again.

Yeah, maybe we can follow up offline on on kind of the timing aspect of amortization, but on the swap side.

The $550 million in swaps.

That were rolling over this quarter I assume that's already been rolled.

Where along the yield curve did you replace those swaps.

We are looking at.

Every swap we put on in the last.

How many months or whatever and we have we don't necessarily just replace swaps as they roll off it really depends upon what we're trying to accomplish with our duration gap.

Our looking at potentially locking in lower financing cost in the future et cetera, but we have been staying.

All the swaps that we've been putting on have been the two to three year part of the curve, we haven't bought any longer or shorter for the most part.

But.

Obviously, we we increased our swap position somewhat in a lot of that at the time was we were looking at.

Swap rates that were cheaper than our plot of repo financing and so obviously in hindsight the market rally offsets that but if you look at our average outstanding swap coupon its around.

Two in a quarter or whatever which is still.

Cheaper than spot rebound, obviously, the market's pricing that through that guides and most of that rally came from may to June .

And so yeah do over she wouldn't want as many swaps on but we thought that was a still a fairly conservative.

Yes, 70% of our liabilities hedged effectively and then have upside on the remaining 30% of the fed does cut.

Now we will monitor that over time, we may not be at 70% of our liability said it could be less it could be more.

But that's kind of what happened this quarter and especially the book value decline was he just kind of do the simple math on the swaps and assume a swap that roughly a two year duration.

We lost a little over a point in value on our swaps and our bonds only improved about a half a point because mortgage spreads widened.

Arm spreads widen 20 to 25 basis points, and we had roughly 70% of our liabilities hedged. So if you do the math it it kind of backs into it to the book value.

Numbers.

Yes, but just confirming that that 550 million was rolled into a new two year swap this quarter.

And that previous swap how to pay rate of 140, and I assume that you know roughly speaking the new swap has a pay rate of 170 180.

Oh, I think what Robert was saying was it wouldn't necessarily be rolling over the swaps just because they are maturing.

Looking at the total picture and we may be adding some swaps we may not be.

I think in my remarks, I pointed out that with the fed looking to reduce rates, we can enjoy more of that benefit.

With fewer swaps and we do have swaps maturing money.

Okay, and where are you guys rolling one month repo today.

Well.

That's kind of a moving target with most recent stuff that we rolled this.

A week or so ago its pricing in park, partially that eases up kind of the.

Mid to Fortys, we would think that if the fed does these 25 next week, we'll be rolling new repo in the 230 to 35 area.

Okay.

Alright, Thank you for the comments.

Sure.

Again, if you have a question. Please press Star then one the next question comes from Steve Delaney of JMP Securities. Please go ahead.

Thanks, Hi, good morning, everyone Youre pretty busy down there in the second quarter on on both sides of the balance sheet. So.

Definitely sense that you are looking at the environment and trying to.

To to shift you know to two greatest advantage possible.

I guess, where I would like to start is you know I'm looking at your reported interest income on the portfolio of 85.1 million up a little over a million and I'm looking at my model and obviously, we had higher Prepays and and you know we had a figure closer to 82 million in our model.

So.

Still in that you guys used to have a rule of thumb where.

A 1% increase in CPR would would cost about one and a half cent on es and from the comments that you've made this morning, I'm hearing that maybe but that we should kind of broke that figure out the window. It certainly didn't look like it was applicable you know when you had almost a 6% increase in CPR in the second quarter is is there a figure that you can give us to quantify.

The EPS impact of about a 1% shifting CPR either up or down at this time.

I don't think we can point to a specific figure because it is going to be it. It is going to morph with level of prepayments. We see higher prepayments are going to result in more amortization, but we have taken some of the cyclicality and seasonality out of Vicki or.

Amortization.

Equation.

With how we estimate the prepays. So yeah, yeah, Yeah, we're definitely not a you know a you could argue we're not being as conservative but you could also argue that we were.

Very conservative in the past.

Well you you you war and it led to obviously quarter to quarter volatility right in terms of just just the seasonality regardless or rate moves you know and our model is kind of crazy, but you know weve had that.

Down Q1 Oh been down in Fourq, you and it's it really is makes it you know kind of crazy to follow especially for people that aren't close to the story is Eric and I, you know might be.

But I do appreciate your comment you are saying in your earlier response about your methodology for premium and I'm hearing you clearly convey.

That.

You are on it.

And I'm not trying to put words in Europe . These are my words, not yours feel that you were trying to smooth out the impact of quarter to quarter CPR volatility to get something some sort of a smoothing. If you will that is that is kind of true up a true up on an annual basis as opposed to the big quarter to quarter I'm sorry.

I think that what from a modeling purpose, we need to do is to come to more of a it's the range you have your CPR just to be.

Oh simplistic if it was going to be 20% at the low and 26% or seven at the high.

Yeah, I, probably would take the mid point around 23 ish or something like that and just every change my quarterly CPR to something along those lines and I'm curious if.

What is this is that type of approach.

Sounds like the advice that you would give to new analysts that decide to come in and pick up coverage on CMO.

Yes, Steve This is lance I'll answer that.

I would say that's fair you know I think one of the things we're real careful on we've looked hard at EUR estimates and as Phil described a couple of times, we have tried to know.

Mmm those estimates.

With the latest news and moving more of a lifetime estimate.

Yes, lifetime, but I think ultimately.

You could model generically something similar to what you described it because we're we have a longer horizon in investment.

Well that's helpful.

And I'm glad you used to I didn't want to use the term lifetime looks like life is can be long, but I. Appreciate that's that is the context I think that many of your peers. You says they you know quarter to quarter, but it's a lifetime assumption some disclose it some don't but that concepts I. Appreciate the fact, you use that that phrase because it. It helps me understand kind of where you guys are on this.

No. That's good for you and you know arms, the or you need so while I will use that also will not you don't want to say that those lifetime asked them to continue to be a challenge.

It was something I assume engine, we look at on a regular basis.

To try and do the best we can with it but hopefully that gives you some note for modeling purposes.

Yeah, and Robert Thank you for your comments on repo, Yeah, we had assumed that it the market had not really fully priced in a cut but it sounds like you are getting some relief from where we may be worth you know 30 days or go already and your mid yeah. They they never pricing into the [laughter] dissipate and things like that with pricing and then of course.

Lot more prices at all land right because LIBOR is a real market and the dealers just sit there and say Oh you know we don't know you anything if it hadn't done anything so I get it.

But work with that that to 30 to 35, you know going into the <unk>. The <unk> the <unk> towards the end you know.

After September timeframe.

It sounds like we're pretty much definitely go get something here on the 31st my last.

Last question guys is you know I totally support the dropping to hedge accounting and go into court T.S. It out its long it's a very positive move in my mind a for you to made that I just need some company that was just last quarter and this quarter you terminated I want to say it was an $800 million swap in June .

It looks like there's a you know you have in your GAAP EPS you have derivative expense of 74.8 million and then I see three different.

Items in the core reconciliation.

And I guess my question is is it it doesn't look like it adds up exactly but is there is there anything that is in the core record wrecked core reconciliation that you were adding back that is not already reflected in your gap bps.

Like a one timer or something like that.

Well, we did we did have we did sell about 300 million of bonds and so we had a million for realized portfolio lost that ran through earning power.

Ordinarily that just would have been an unrealized loss running through book value.

They be there was more real ice swap loss, because we terminated early 800 million of a 30 month or.

To term out of swaps and replaced right do.

24 month swapped at significantly lower rates, so that kinda distorted the relationship between the unrealized loss and the realized swap.

Result.

So I guess, that's that's honing in on it still in the 20 to 24.2 million add back for the realized loss I'm. Just I guess my question is is that add back.

Relate it is there a unrealized you reclassifying unrealized loss to realize loss.

Well effectively our because you you you've terminated those positions. So you book Okay.

As realized and then the new position that came on because it's in the same position effectively from a hedging perspective, we've locked in the lower.

Fixed pay rates on the.

New swaps out that.

Duration.

We actually reduced or.

Term on those swaps, which was very important to the.

Doing the trade.

We went from three months to 24 on that.

Okay, and you are saying.

Sorry go ahead Ryan.

So the answer is absolutely correct I just want to make sure that we realized in gap.

And we know who they are realizing who earn him. So there's no swap between.

Unrealized or no switch between unrealized in gap and realizing for I want to make sure that.

Well Yeah core continues to include the cash flows off the active swaps and that pick right 7 million positive is just running off the gain in that those swaps that were there when we ceased hedge accounting at the end of February .

Correct I remember that that we would have that each quarter for a while so until that is run off sorry.

Okay, guys look thanks for the comments if I have anything else as we go into the model I will I will react reach out thank you.

Yeah.

Our next question comes from Gabe Poggi of shows capital. Please go ahead.

Hey, guys. Thanks for taking the other question I. Appreciate that you guys are going to provide a good to Eric and Steve's point of of what the estimated.

How you guys are thinking about estimated prepays going forward and Lance you noted kind of a lifetime adjustment can you talk about what assumptions go into that assumption specifically, how you guys are thinking about the forward shape of the mortgage curve.

And what I'm getting at is you talk about the fed lowering rates and obviously, we're probably get 25 basis points next week.

I'm trying to get a gauge as what happens if the long end of the curve follow suit and we just continue to get a big Flattener and how you guys think about that in conjunction with those prepayment estimates. Thank you.

Sure I mean, we.

Run estimate prepay speeds on three or four different models on it and.

The.

As far as now there is not a uniform consensus on or prepayments out there and there's not much times that modeling on prepayment.

There is there. So there are a lot of moving parts and you can get three different answers on three different models and so when we're looking at things, we will model that into the forward curve into the static or and.

And a given point in time, obviously, it long enough for those models were going to.

Kick up the rents that's more on certain bonds than others right right now what's going on at arms as I said earlier very seasoned bonds.

Some of these guys are seeing their their mortgage rate dropped 75 to 100 basis points from where they reset last year and because of that and where the forwards are right now it assumes those bonds. If you look at the life speeds on those bonds now versus.

Six months ago, there are lot flow. Conversely, if you take a.

You know a call it a new issue.

So the one with the.

Three and a half coupon it band it they didn't model that 15, CPR six months ago, and it's my model that 20 to 25 CPR now so it.

When we look at we look at it versus static and the anticipated forward curve at that point in time, and that's what goes into our lifetime assumption, we don't really.

You know, there's so many potential scenarios out there we don't model everything but those are what we look at when we look at life speeds on our bonds.

Hi, guys I'm, just trying to get a gauge of what I understand there's a lot of models out there, but what specifically you guys are focused on.

To come up with that estimate just because you look at the static speeds over the last few months and they really ramp and obviously you know you mentioned, it's up 6% and 26, CPR, but just thinking about that in conjunction of the new estimate kind of how you're looking at things now as last two quarters with that change and I. Appreciate you being conservative in the past, but kind of how that how you how you ebb and flow with that depending on the shape of the mortgage curve I guess the answer as you just taking what the forward curve is showing you today and basing it off of that and if things change and I assume you'd have to make a change is that correct, yeah and we're at a point right now for instance, where we yeah.

Bonds. They are prepaying. It at 15 to 17, CPR and models that lives speed as high as 25, we had bought their prepaid at 25, right now where models have lightspeed going down to 15.

So you're a very interesting point I mean basically.

As I said earlier newer issue longer reset paper like speeds are projected to go higher very seasoned post reset paper, where they are adjusting down are projected to go lower and so you're going to have kind of a convergence between is it yeah whatever that speed is but that's kind of what the trend of the market is right now and yeah, it's totally different than where we were six months ago and it could be totally different six months from now.

Correct me, if I'm wrong, having a lot of the season stuff prepaid pretty fast over the last couple of years.

Well, yes, that's what I'm, saying so yes.

Out of the season.

Yeah, a lot of the season paper it sped up because.

The bars, we're seeing their rent increase and so.

And so they sped up beyond with Lightspeed would would've expected and right. Now you are actually seeing friends on our very very seasoned arms last month.

They they're drop was much more precipitous than other cohorts. They they declined as much as 20% from June to July and yeah. The aggregate arm cohort declined 6%.

So you never know I'll start off a really high prepays right. They were not 20% decline was often very high speed, yeah, well it depends on the on the on the.

The the way in the wall et cetera, but.

You saw that as much as the five CPR drops of bonds that were pretty bad. It 30 with the 25 module prevent 25 with a 20 month.

See the cohort.

Got it okay. Thank you that's helpful.

Sure.

This concludes our question and answer session I would like to turn the conference back over to Lindsey Crabbe for any closing remarks. Please go ahead.

Thanks again for joining US today you have further questions. Please give us a call. We look forward to speaking with you next quarter.

The conference has now concluded. Thank you for attending today's presentation you may now disconnect.