Capstead Mortgage Corporation
Q1 2019 Earnings Call Transcript

Published: 25 Apr 2019

[Operator:]

Good day, and welcome to the Capstead Mortgage Corporation First Quarter 2019 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would like to now turn the conference over to Lindsey Crabbe, Manager of Investor Relations. Please go ahead.

[Lindsey Crabbe:]

Good morning. Thank you for attending Capstead's first quarter earnings conference call. The first quarter earnings release was issued yesterday April 24, and is posted on our website at www.capstead.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 July 24, 2019. Details for the replay are included in yesterday's release. Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995 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. This information – the information contained in this call is current only as of the date of this call April 25, 2019. The company assumes no obligation to update any statements including any forward-looking statements made during this call. With that, I'll turn it over to Phil.

[Phil Reinsch:]

Thank you, Lindsey. After a few brief remarks, Lance will give a recap of the quarter and then we'll open up the call up for questions. We're pleased with our first quarter results. Both our core earnings and our book value increased over the prior quarter producing a quarterly economic return of 1.3% or 5.1% on an annualized basis. With the welcomed recovery in our stock price from depressed levels seen in the fourth quarter, we did not repurchase any common stock this quarter instead opting to redeploy capital from run-off into attractively priced agency guaranteed ARMs securities at estimated ROEs of nearly 11%. Going further than just replacing portfolio run-off, we increased the portfolio over $200 million in this quarter and increased leverage modestly to 9.65 to 1 from 9.49 to 1 at year-end. With it now increasingly evident that the Fed will be on hold this year, and may even need to eventually lower the Fed funds rate to spur inflation, we have become increasingly bullish in our prospects. With borrowing rates stabilizing we have the opportunity to continue to recover financing spreads, diminished by past Fed funds increases over the course of this year through higher yields on acquisitions and coupons resets. With the current growth WAC on our current reset ARMs securities averaging in the neighborhood of 4.6% and only around 25 basis points available to reach fully indexed rates at quarter end and together with our longer to reset ARMs securities averaging growth WACs of about 4.1%, we do not have as much exposure to refinancing as in years past given that current 30-year no cash refinancing rates are north of 4.5%. As a result, we do not expect mortgage prepayment rates to increase appreciably in the coming quarters. This is contributing to our optimism. Further, we have the opportunity to see improvements in book value as bonds in our portfolio that previously declined in value due to below market current coupons and relatively high pre-payment expectations, seasoned through their fast prepaying initial reset periods over the next several years. With that, I'll turn the call over to Lance.

[Lance Phillips:]

Thank you, Phil. I would like to start by highlighting a couple of important updates and financial reporting that we noted in our earnings release yesterday evening. We stopped using hedge accounting on our swap agreements associated with our repo financing. As a result, beginning March 1, changes in fair value on those agreements run through our statement of operations as opposed to staying on the balance sheet in AOCI. Related to that change in accounting, we have also introduced a new non-GAAP metric core earnings, and the related core earnings per common share. This change will allow more flexibility in managing our portfolio and the swap book in the future. It also saves on future operating expenses in administrating the hedging program. We believe these metrics allow investors to more effectively evaluate and compare our performance with that of our peers. As in any non-GAAP metric, this should be viewed as a supplement and in conjunction with our GAAP results. Having said all of that, we incurred a GAAP net loss of $7.7 million in this quarter, or negative $0.15 per diluted common share. Our core earnings were $15.5 million or $0.12 per diluted common share. The difference between GAAP and core earnings consist of $26.2 million in fair value mark-to-market changes and our swaps since de-designation of hedge accounting and $3 million of amortization of the net gains for swaps included in AOCI at the time of de-designation. Portfolio yields averaged 2.75% during the quarter, an increase of 41 basis points from the 2.34% we reported in the fourth quarter. Yields benefited from our mortgage loans underlying the portfolio resetting to higher rates. We also incurred less premium amortization as a result of declining mortgage prepayment rates, lower pricing levels on recent acquisitions, and changes in prepayment estimates. Unfortunately, our borrowing cost did increase as we saw our secured borrowing rate increase nearly 16 basis points over the prior quarter. This is largely the result of the 25 basis increase of the Federal funds rate in December 2018, partially offset by our existing hedges. Book value increased $0.04 per share during the first quarter ending at $9.43 per common share. Coupled with our $0.08 common dividend, we produced an economic return of 1.3% for the quarter or 5.1% annualized. Breaking down our book value from an activity perspective, our portfolio increased in value by $0.51 during the quarter, while our swap agreements declined in value $0.49. Our core earnings exceeded our divided by $0.04 and which was partially offset with a $0.02 reduction due to stock compensation related activity. With that, we will open the call up to questions.

[Operator:]

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question today comes from Eric Hagen of KBW. Please go ahead.

[Eric Hagen:]

Hey thanks. Good morning. Good morning guys. So, Capstead has typically amortized the premium in its portfolio based on the observed prepayment speeds during the period. I'm just wondering if that's still the case or have you guys made an accounting change to the way you amortize your premium in conjunction with the hedge accounting departure? Thanks.

[Phil Reinsch:]

Thanks Eric. No, we haven't changed accounting methodology on our amortization of investment premiums. We did make some changes in prepayment estimates this quarter though.

[Eric Hagen:]

Okay. So, what is the forward prepayment estimate for the portfolio?

[Phil Reinsch:]

We don't -- we haven't ever really gotten into that kind of detail with our public disclosure. So, I might have to find it.

[Eric Hagen:]

Okay. What was the premium amortization for the period itself? I mean I feel that -- just looking at my model, I think Capstead has disclosed that number every quarter for the last decade at least. What was that number in the first quarter?

[Phil Reinsch:]

Well, I don't know that we have that in our public press release. We'll have it in the 10-Q certainly.

[Eric Hagen:]

Okay. Okay. And -- okay so how -- I think you guys have alluded in your opening remarks about the cash out refinance activity for hybrid ARMs. What -- give a sense for the percentage of cash out activity for the overall space over the last call it few years?

[Lance Phillips:]

It's continued to drift up. I want to say the last number's cash outs were up to -- close to 60% if memory serves me right. But they've gone up significantly over the last few years. Cash outs are generally more prevalent in newer issue type securities 51s et cetera. I will point out that as far as speeds go, I think some positive trends. Last month for instance as we saw fixed rate prepays kicked up about 20% or so, albeit from a lower level and ARMs speed -- Fannie ARM speeds, the entire population only kicked up about 12%. And so you're starting to see some -- we actually saw very seasoned cohorts slowdown in speeds. And so some of the things we've been talking about as far as borrowers not seeing their rates go up anymore, it's starting to take hold in our more seasoned portfolio. And if you think about it guys that are resting right now on very seasoned paper, their rates aren't going up from last year. And once you get into September/October, those borrowers will actually see decreases in their mortgage rates above the 50 basis points. So, between that and the Fed signaling that they are done and potentially easing, I think we're starting to see some of the prepay activity slowdown and more seasoned securities.

[Eric Hagen:]

Okay. Okay, great. Thank you for the comments.

[Operator:]

Our next question comes from Steve Delaney of JMP Securities. Please go ahead.

[Steve Delaney:]

Thanks. And nice to see a solid rebound in earnings guys. I want to start with repo. Hearing some things that led me to think there is some flux in the market not in terms of lack of availability, but just in terms of where repo is relative to three-month LIBOR. And it seems like that -- what was a favorable spread is maybe now a negative spread. And just curious if maybe what we're seeing there is -- especially with hedge funds et cetera that maybe there's actually less demand now in the agency repo market than there was six or 12 months ago. And I've heard some comments that haircuts were coming in. So, I guess, Robert anything you could share to help us understand the right hand side of the balance sheet that would be appreciated. Thanks.

[Robert Spears:]

Sure. We're actually a little surprised that 30-day repo rates haven't come down further than they have and I think there are a few actors there. I mean, right now, one-month LIBOR is around 248 and spot repo is around 260. We would have expected that to be relative to 250 by now, but it's not. And I think there are a few things going on. I think there continues to be a lot of bill issuance and those securities have to get -- or a lot of them are getting funded in the repo market. At the same time, if you think about what's going on in the fixed rate market, a lot of guys used to own a significant percentage of their fixed rate bonds in TBA form and we've all seen different people disclosing now that a much higher percentage of their book is in specified pool. So if you just think about that, that number -- if a guy was 50% TBA and now he's 90% specified, there's a lot of MBSs to apply that it will now be in repo, that it wasn't in the past. And I don't think there's a shortage or a lack of availability. I think there is some pricing discrepancies and I also think that guys are looking at the -- where the stuff is funding through FICC markets. And guys that actually have, again, repo to provide are using that to their advantage and maybe keeping that spread a little wider than it should be. So I think it's a combination of all those things. We're positive though in -- from what the Fed's saying. They're talking now about essentially establishing a repo facility. They obviously have also said that they're going to a treasury-only portfolio and have indicated that they're going to buy all along various points of the curve, including bills. So I think once a couple of those programs take hold, we should see repo rates drop back down to more normalized levels than they are right now.

[Steve DeLaney:]

That's helpful. So you're saying that you're seeing current quotes in the 260s?

[Robert Spears:]

About 260 with -- like you mentioned three-month LIBOR at 258, one-month LIBOR at 248. For most of the last couple of years, if you wanted to use LIBOR for a proxy, we were funding closer to LIBOR plus a nickel. So you would think we'd be closer to 253.

[Steve DeLaney:]

Go it. Okay. All right. That's helpful. Thank you. And interesting, your comments about the -- where rates have moved and that the second half of this year, you could actually see some borrowers reset lower. And maybe that's more of a calendar type issue than seasonality. But any reason that for spring and summer that we shouldn't -- last year we saw a move from the 20-ish range in the first quarter to sort of a 24, 25. So just thinking not so much into the year or next year but for the middle part of this year, do you think 24 to 25 would be a good level for us to model as far as speeds?

[Robert Spears:]

Yes. I mean, I think, if you were kind of in 20 in the first quarter, I think, speeds will pick up probably. I think, most forecasts have, like, fixed rates, for instance, going up 15% to 20%. The one positive trend, though, at this point ARMs don't seem to be going up at the same percentage like the fixed rates are. They seem to be going up a little slower. But I still think there's a decent chance to get into the mid-20s. So I don't really have any -- yes, I don't quibble with that thesis at all.

[Steve DeLaney:]

Okay. And then the last thing for me. Phil, you mentioned 11% marginal ROE opportunity. Just wondering if you guys could break that math down a little bit as far as the asset yield that you're looking at, how much leverage is embedded in that? It will be helpful to kind of just understand that basic algebra. Thanks.

[Phil Reinsch:]

Yes. To be clear, that was what we got in the first quarter. We're not -- we won't…

[Steve DeLaney:]

Absolutely, yes.

[Phil Reinsch:]

…probably see that for the rest of the year. I'll let Robert break that down for you.

[Robert Spears:]

Yes. Actually, Steve, we're looking at kind of 75 to 85 basis points and carry on a hedge basis. And if you notice too, we have shifted a -- number one, we've taken our duration gap down to zero months from four at the end of year and we've been using a lot more three-year swaps. And those are -- that part of the curve is inverted, the 235 on a three-year swap versus whatever 242 on a two-year swap. And for us, particularly when we're purchasing longer reset bonds that two to three-year duration area is kind of where those fall. And so we don't think going out to the three-year part of the curve is much of mismatch. Going out beyond that for us kind of is. And so, we have taken advantage of that inversion. Obviously, the market is now pricing in almost two Fed decreases. And so, we're adding a little book value protection at the margin and via the swap market funding our current book much cheaper than spot repo. And we just think that makes sense at this point in time in the reset.

[Steve DeLaney:]

No, it certainly does. And so, on your 80 basis points of carry, what sort of net MBS yield after amortization would you be looking at?

[Robert Spears:]

Kind of the…

[Steve Delaney:]

Just on the asset side.

[Robert Spears:]

Well, the low three. But once again just taking that 235 as a proxy and then just add 75 to 85 basis points to that. And, obviously, yields were higher in the earlier part of the quarter and a lot of those purchases -- we advantageously bought a lot of bonds in January and February because you still had some overhang from year-end where dealers were loaning some paper and there was a decent amount of supply. I think that it has come in a little bit since then.

[Steve Delaney:]

Great. That’s all helpful color. Thank you guys.

[Robert Spears:]

Sure.

[Operator:]

[Operator Instructions] Our next question comes from Gabe Poggi of Shoals Capital. Please go ahead.

[Gabe Poggi:]

Hey, good morning guys. A question on the 41 basis point increase in yield. How much of that 41 basis point increase came from your estimated change in forward prepay speeds?

[Phil Reinsch:]

We haven't really broken that down in our earning spreadsheet release.

[Gabe Poggi:]

…give or take?

[Phil Reinsch:]

Excuse me?

[Gabe Poggi:]

Was it a decent size chunk of the 41 basis point? I'm trying to get a gauge of…

[Phil Reinsch:]

Yeah, yeah it was. It was.

[Gabe Poggi:]

And as you guys are thinking of speeds going forward, obviously, the set is pivoted and so you're changing your estimates. But the curve is still very flat. And so just trying to get a gauge of how much of that increase from 4Q was due to estimated changes as compared to just…

[Phil Reinsch:]

Well, and not just estimated changes. We had an overall decline in prepayment rates of 8% for the quarter. And acquisitions this past year have been coming on to the balance sheet at a lower basis point than the preexisting portfolio. So a combination of things including changes and prepayment estimates resulted in over half of that 41 basis point increase in yields.

[Gabe Poggi:]

Got it. And then one more question and I just want to make sure I heard right. Steve just asked about speeds going into 2Q, 3Q. You guys are comfortable in the thought process that things pick up in the 24, 25-ish range. Just looking at historical seasonality and where we are shaking out and the actual speeds coming there relative to what you guys are estimating, is that in that ballpark?

[Phil Reinsch:]

Well, I think we indicated that we were not going to quibble with that estimate on Steve's part. Whether it reaches that high over the summer months is another question. It could be better than that.

[Gabe Poggi:]

Got it. And one last for you. If for whatever reason, obviously, Fed has made a pivot. For whatever reason economic activity were to pick up and they were to re-pivot back to potentially increasing rates again, what do you think that the impact would be on how you guys are thinking about estimated forward speeds?

[Phil Reinsch:]

Probably going center around how the rest of the rates market reacts. Robert, I don't know, you got some thoughts on that?

[Robert Spears:]

I mean, obviously, if the Fed changes direction and starts tightening then if that tightening causes the curve to flatten or invert for instance that would not be a positive. If the market -- if loan rates go up because they're worried about the Fed tightening and the curve steepens it would be a positive for prepays. So it really -- it totally depends upon your view on the slope of the curve if that does occur.

[Gabe Poggi:]

Got it. Okay, that's helpful. It's the function of kind of the steepness of the curve. Okay, guys thanks very much. I appreciate it.

[Robert Spears:]

Sure.

[Operator:]

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

[Lindsey Crabbe:]

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

[Operator:]

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