Capstead Mortgage Corporation
Q4 2019 Earnings Call Transcript

Published: 30 Jan 2020

[Operator:]

Good morning. Welcome to Capstead Fourth Quarter 2019 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note that this event is being recorded.I would now like to turn the conference over to Lindsey Crabbe, Director of IR. Please go ahead.

[Lindsey Crabbe:]

Good morning. Thank you for attending Capstead's fourth quarter earnings conference call. The fourth quarter earnings release was issued yesterday, January 29, 2020, 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 April 29, 2020. Details of the replay are included in yesterday's release. With me today are Phil Reinsch, President and Chief Executive Officer; Robert Spears, Executive Vice President and Chief Investment Officer; and Lance Phillips, Senior Vice President and Chief Financial Officer.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. The information contained in this call is current only as of the date of this call, January 30, 2020. The company assumes no obligation to update any statements, including any forward-looking statements made during this call.With that, I will turn the call over to Phil.

[Phillip Reinsch:]

Thank you, Lindsey. After a few brief remarks, Lance will give a recap of the quarter, and then we'll open the follow up questions. Fourth quarter earnings benefited from lowered borrowing rates, due in large part to a total of 75 basis points and Fed cuts last summer and fall. We also took advantage of lower prevailing interest rates to further reduce our swap costs by replacing higher rate swaps with new swaps with lower fixed rates.Additionally, returns on the floor in our capital in the agency guaranteed ARM securities continued to look at practices. This earnings improvement came despite rate pressures and short-term funding markets that contributed to elevated repo borrowing rates relative to Fed funds and other short-term rates. Note, I referenced rate pressures, not availability. We continue to find repo to be readily available through our network of lending counterparty. And even as repo rates remain elevated relative to Fed funds from a historical perspective, post-quarter-end, we're seeing repo rates 30 to 35 basis points lower than the average rates incurred last quarter, with the caveat that we still expect some degree of upward pressure on rates each quarter and going forward, asset regulatory or other release that reduces disincentives for major banks that fully participate in the short term funding market.Given these dynamics, we anticipate further significant improvement of our borrowing costs going forward in an environment where the Federal Reserve may be on the sidelines for most, if not all, of 2020. These lower borrowing costs, together with attractively priced portfolio acquisitions, will serve to offset lower portfolio yields as mortgages underlying the current reset component of our portfolio reset the lower rates and mortgage prepayment levels remain somewhat elevated.With that, I'll turn the call over to Lance.

[Lance Phillips:]

Thank you, Phil. We reported a GAAP net income of $32.7 million this quarter, or $0.29 per diluted common share. Our core earnings were $19.1 million, or $0.15 cents per diluted common share. The difference between our GAAPs and our core earnings this quarter primarily relates to market-to-market activity, and our interest rate swap agreements, which are included in our gap results and excluded from core earnings. We include a reconciliation of these differences on Page 9 of our press release.Portfolio yields averaged 2.67% during the quarter, a decrease of 9 basis points from the 2.76% we reported in the prior quarter. Yields declined primarily due to lower cash yields as a portion of our ARM portfolio reset to lower prevailing interest rates. Our portfolio-related borrowing costs, after adjusting for our hedging activities, averaged 1.97% during the fourth quarter, 34 basis points lower than in the prior quarter, leading to a 25 basis point improvement and net interest spread. The benefit of lower un-hedged repo rates and lower fixed rates on our swap books were partially offset by the continued decline in three-month LIBOR, which negatively impacted the received leg of these derivatives. At December 31, the fixed pay rate our swap books was 1.77%, a decline of 27 basis points from rates in effect on September 30. This helps illustrate how repositioning our swap book will benefit future earnings.Book value increase two cents per share during the fourth quarter, aiming at $8.62 per common share, reflecting a $0.19 cent increase in value associated with our hedging activities, offset by an $0.18 decrease in portfolio-related unrealized gains.With that, we will open the call up to questions.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Eric Hagen some KBW. Go ahead.

[Eric Hagen:]

Good morning. What was the portion of the dividend paid in 2019 that was characterized as a return of capital? For 2018, roughly a third of your dividend was a return of capital, and I know the reason for capital return varies among rates. But can you just remind us what drives that return of capital for Capstead?

[Phillip Reinsch:]

I think 2019 was pretty unusual in that we put a lot of realized losses, rather than unrealized loss in value our swap book. By repositioning the book, we created taxable losses, which pretty much covered up all the dividend distributions we had last year, such that we've reported to the broker dealer community and everywhere else we need to that none of our distributions last year are taxable.

[Eric Hagen:]

None of them are? Okay, interesting. Okay, great. Maybe I could follow up with you guys after the call and just kind of understand the taxable impact there. It would be great to hear your outlook with regard to what the transition to SOFR from LIBOR means for the agency hybrid art market, and just what a transition like that can do to the prepayment speeds in the market and the net supply, as well. And a segue to that question would really just be how you guys are thinking more generally about just remaining a pure play strategy and agency ARMs right now. Thanks.

[Phillip Reinsch:]

So, regarding the SOFR transition, the ARCC came out with a concept release just last week that indicated - asking for comment on a solution to consumer products that - such as farm loans to handle the transition, and their approach makes a lot of sense. They're going to publish a series of indices based on tenor, whether it's overnight, one month, three months, six months, 12 months, like LIBOR would report; and they're going to add a spread adjustment based on historical relationships. It has come out with a like-minded approach. So, we actually are pretty encouraged about that solution. We think it makes a ton of sense for everybody involved, and their goal is to not disrupt the markets in any way and treat everyone fairly. So, they have a lot of support from all participants, and that looks to be where the answer is headed for consumer products like farm loans. Relevant to pre-paid's, I don't know. Robert, do you have any opinion on that? I don't see any real impact.

[Robert Spears:]

No. I mean, if they do what they're saying right now, I mean, the mortgage servicer would just pick up whatever the new index is, and it should be adjusted, looking at regression analysis to make up for that differential between LIBOR and SOFR. So, if that is the case, and the adjustment is fair and accurate, there really won't be any difference in the underlying mortgage rates to the consumer. So, I wouldn't think it would affect pre-payments at all if they do what they said they - in the release last week.

[Eric Hagen:]

Okay, how about the second part of my question? Just a segue and just how you guys are thinking about remaining a pure play strategy and agency hybrid ARMs as we open up to the new year here.

[Phillip Reinsch:]

Sure. We're a short duration play, and if that means we branch out beyond just adjustable rate mortgage - I think it's a guarantee to adjustable rate mortgage rates securities. That can happen. We're already buying more seven ones than we used to, and Season 10 ones. So, that's a natural extension, is if we're able to succeed in growing a larger capital base, prior to ARM supply starting to pick up with a steeper curve at some point, then we would look to potentially add some other short duration strategies to our existing strategy.

[Eric Hagen:]

Okay, thank you very much.

[Operator:]

[Operator Instructions] Our next question is from Steve Delaney from JMP Securities. Go ahead.

[Steven Delaney:]

Good morning, everyone. Thanks for taking the questions. So, I'd like to - obviously you guys have been very proactive in managing your swap book, and it looks like there's probably still some benefit. Wanted to run comment by on your 2020 expiration. So, we're seeing You know, $1.2 billion over the course of 2020. We get an average pay rate of about 2% there. So, that's 60 basis points I guess above where swaps are today. So, we're getting about a blended - if we roll all those off, and let's just say you replace them at 140 over the course of the year, we're seeing about a 10 basis point additional benefit to your overall financing costs. I'm just curious if that seems like a - not asking specifically, but is that a ballpark that you would think as far as incremental benefit to your financing costs from the 2020 expirations?

[Phillip Reinsch:]

Yes. Well, just to be clear, you're talking about 2020 expirations and not the benefit we have standing on January 1 of having lowered our rates to 177 down.

[Steven Delaney:]

Yes, 177 is where you were at December 31. Right?

[Phillip Reinsch:]

Right, yes.

[Steven Delaney:]

Yes, exactly.

[Phillip Reinsch:]

Yes, which is a very nice rate, relative to where we're repo-ing right now. So, I haven't done specifically the math with that, but that sounds like the right perspective to take.

[Steven Delaney:]

It wasn't any calculus build. I don't do well with higher math, but I'm seeing 60 basis points difference between the 20 - if you look at the 2020 expirations they are about 2%, and the current markets 40. So that's 60 basis points, and they represent about 16% of the total swap book. So, like I said, higher math.

[Phillip Reinsch:]

It looks like roughly 2% so yes, doing that math, I think that's pretty much spot on.

[Steven Delaney:]

All right. And Robert the - it's - I guess, in the belly curve is at flat. I mean, you've been - you guys have been doing three years I think on your new, but given where we are in rates, and - would you be tempted to maybe push some of your new swaps out the five years just to kind of lock in these unexpectedly low rates, or at least in my mind unexpectedly low?

[Robert Spears:]

Yes, and we've actually been doing more two-year lately. The only thing is, given what we're buying in this type of environment, we have a lot of five-year swaps on for us. We really don't have that type of duration and our book. If the market continues to rally, we can get upside down pretty quickly because the upside of price on the ARMs is not going to be enough to compensate for that additional risk on the swaps. And so, not saying we wouldn't put any on, but in all likelihood, what the bulk of what we're doing is going to be closer to two-year tenors because it just matches the duration of our book better.

[Steven Delaney:]

No, that makes sense. It's got to be balanced on -

[Robert Spears:]

Just like last year, for instance, and there were points in time where that trade looked great and it - potentially, but then if you look at what happened by the end of the year, we had 100 basis point rally and ARMs spread wide in 30 basis points. So, they basically improved almost a point less in price than you would have expected. We would have gotten crushed last year, had we done that. So, we could do a little bit of it. I wouldn't look for us to do a lot of it.

[Steven Delaney:]

Okay, thanks. That's helpful just to outlook on how you see the market, and it sounds like you see current investment opportunities, some, - sounds like you see those as pretty attractive.

[Robert Spears:]

Yes, I mean, I think ARMs in the fourth quarter maybe tightened versus swaps five basis points or so, but I still think right now, we're kind of looking at 10% to 10.5% levered returns, and 79 times leverage. So, we still do that. It's very attractive, and, on a performance basis once again, fixed rates knocked it out of the park in the fourth quarter, in fact, more than ARMs did. But so far, year to date, that starting to reverse a little bit because I think fixed rates are falling [indiscernible] and ARMs are pretty close to flat versus their buy, hedge ratio. They're making up a little bit of the underperformance in the first quarter so far.

[Steven Delaney:]

I want - one quick thing just to close out. Obviously, we understand your change and your premium amortization and, and we're trying to - I think we put a new model out, and trying to learn as we go a little bit, and I think we were reasonably close here in the fourth quarter. But you're still running [Technical Difficulty] $18.5 million of amortization in the fourth quarter represents about a lifetime assumption of about 23%. I'm not asking you to comment on that. But if that's even close and CPR is 29 to 30, how frequently will you evaluate that lifetime assumption?

[Lance Phillips:]

Yes. So, Steve, this is Lance. We do monitor the lifetime speeds continuously, and we'll update it as warranted, like we did last year. And I will tell you, I think we all feel like we're at the higher end of the range, but not - unfortunately not surprised by the current higher speeds. So, other than kind of monitoring what's happening, we don't have a set schedule when we'll change as much as if something on our overall expectations change going forward.

[Steven Delaney:]

Okay. So I mean, I think what you're saying to us, Lance, is none of us know where rates will be in six months. But if - as an analyst, if I think that we're in for prolonged low rates, then I might - I certainly might want to take a more conservative approach on premium amortization, and so I - and I think that conservatism from an annual standpoint is never a bad thing. Thank you guys for the comments this morning. Appreciate it.

[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.