AG Mortgage Investment Trust, Inc.
Q2 2013 Earnings Call Transcript

Published: 7 Aug 2013

[Operator:]

Welcome to the AG Mortgage Investment Trust Second Quarter 2013 Earnings call. My name is John and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to Mrs. Lisa Yahr. Mrs. Yahr, you may begin.

[Lisa Yahr:]

Thanks, John. Good morning, everyone. We appreciate you joining us for today’s conference call to review AG Mortgage Investment Trust Second Quarter 2013 results and recent developments. Joining me on today's call are David Roberts, our Chief Executive Officer; Jonathan Lieberman, our Chief Investment Officer; and Frank Stadelmaier, our Chief Financial Officer. Before we begin, I would like to review our Safe Harbor statement. Today's conference call and corresponding slide presentation contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such statements are intended to be subject to the protection provided by the Reform Act. Statements regarding the following subjects are forward-looking statements by their nature. Our business and investment strategy, market trends and risks, assumptions regarding interest rates and prepayments, changes in the yields curve, and changes in government programs or regulations affecting our business. The company's actual results may differ materially from those projected due to the impact of many factors beyond its control. All forward-looking statements included in this conference call and the slide presentations are based on our beliefs and expectations as of today, August 7, 2013. Please note that information reported on today’s call speaks only as of today and therefore you are advised that time-sensitive information may no longer be acted as of the time of any reply listening or transcript reading. Additional information concerning the factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the risk factors section of the Company's periodic reports filed with the Securities and Exchange Commission. Copies of the reports are available on the SEC's website at www.SEC.gov. Finally, we disclaim any obligation to update our forward-looking statements unless required by law. With that I will turn the call over to David Roberts.

[David Roberts:]

Good morning, everyone. The second quarter was a difficult one for AG Mortgage Investment Trust and many other fixed income investors. Towards the end of the quarter, there was a sharp rise in interest rates and an even sharper selloff in the agency mortgage-backed securities leading to a widening in the mortgage basis. With this selloff came a greatly heightened level of volatility in the asset classes that comprise our portfolio. Our portfolio was positioned for a continued slow growth economic environment and therefore we had set up our portfolio to protect against both prepayment risk and modestly rising rates. As a result of our positioning and what happened to markets during the quarter, our book value per share declined approximately 14.6% to end the quarter at $19.77 per share. We have determined that the increased volatility and potentially higher interest rate environment we have seen is not compatible with the portfolio we have had in the past. Therefore, we have reduced the size of our portfolio and increased the amount of interest rate hedges we have. While we expect these moves will provide our portfolio with more protection in a rising rate environment, we also expect that they will lower our core earnings. On last quarter’s call I said “In terms of our dividend, based on current conditions and everything we see today, we do not anticipate a change in our dividend rate through the remainder of calendar 2013.” Conditions have definitely changed and we did not foresee the events, I just discussed at the beginning of my comment this morning. The future level of our dividend will depend upon our core earnings, our undistributed earnings and our general outlook. We have always planned for AG Mortgage Investment Trust to increase the percentage of our assets represented by residential and commercial whole loans which are the asset classes we believe can maximize the value add to be derived from the Angelo Gordon platform. We believe the opportunities in these asset classes for an investment manager with the skills and resources of Angelo Gordon will prove to have superior risk reward characteristics particularly in periods of volatility. Therefore, subject to finding the right opportunities and consistent with prudent portfolio management, we plan to accelerate the rotation of the portfolio into whole loans. We continue to add personnel and other resources to which fits us with our whole loan strategies and are very excited about the opportunities in the whole loan market that we are seeing. Now, Jonathan Lieberman will give more details on our current portfolio and our outlook and then finally Frank Stadelmaier will go through the numbers for the quarter.

[Jonathan Lieberman:]

Thank you, David. Before I begin, I just want to let you know that my prepared comments and remarks will be briefer than previous quarters, as we thought it would made sense to leave more time for questions. As David mentioned, we have always indicated our economic and monetary outlook has been one of the fundamental building block for our portfolio construction process. My comments on prior calls reflected our expectation ongoing tepid U.S. economic growth. Economic weakness in Europe and the emerging markets as well is in belief that the Fed would remain supportive of the housing markets by keeping its foot planted on the QE pedal and eventually choreographing a more orderly transition to a taper and ultimately in increasing (inaudible) launch. Like most market participants therefore we did not anticipate commentary from the FOMC depicting a more robust outlook for growth and an earlier start of tapering of future asset purchases. We could sit and we could debate whether that growth will ultimately come through in the second half of this year and into 2014 but we must accept at least a view put forth by the FOMC. While an improved economy is good news for our credit portfolio, the increased uncertainty around future central bank monetary policy led to a sharp rise in interest rates and a widening of credit spreads for most fixed income products. Now, like most market participants, we were not positioned for such a sharp rise and sudden volatility in rates and an even sharper and dramatic widening of the mortgages basis. I mentioned and emphasized many market participants because I think it’s important to realize how market went, what went on, was due to positioning and the result of unwinding of levered carry trades. As a consequence just among some of the sectors treasuries, agencies and municipals, all experienced disorderly market. Our agency MBS portfolio was constructed as David mentioned, to provide prepayment protection and therefore was positioned substantially in core protective lower coupon mortgages. These mortgages would have done exceptionally well in a tepid economic environment, more of the same but would have underperformed in a rising interest rate stronger economic environment. We constructed our portfolio with a view that the Fed was more concerned about U.S. deflation, home prices, unemployment, the deeper session in the European core, a depression of the European periphery, Japanese deflation and slowing Chinese economic activity. We also believe that Dr. Bernacki would error on the side of too much QE3 curtailing monetary stimulus. Clearly, insufficient weight was given to the Fed’s view of the (inaudible) fixed income markets, the expansive growth in mortgage REIT equities and the absolute size of the Fed’s QE balance sheet. Notwithstanding our views on QE and consistent with our portfolio management approach, we had materially increased our hedge ratio over the prior two quarters. So from 53% to the book at the end of September 2012 to 83% of our agency repo book at the end of the first quarter of this year, our hedge policies, we’ve always stated, was not designed to fully insulate the portfolio from interest rate risk or to protect book value completely. Rather it was designed to manage the portfolio performance within a band of economic and interest rate scenarios. In addition, we’ve always stated that we were inherently long in the mortgage basis. As we have reassessed, the predictability of the market and the magnitude of the market moves over the last few months, we decided to reposition into a smaller portfolio which we believe will be better able and capable to withstand longer periods of both higher volatility and limited market liquidity. This more balanced portfolio should be able to tolerate the current interest rate environment, higher volatility and higher or modestly lower interest rates. Unlike the portfolio we’ve historically run we expect this portfolio to have greater sensitivity to higher mortgage prepayment rates. This more defensive positioning will also negatively impact our earnings as David mentioned. Though the markets have retraced a portion of the sell off and are today functioning more smoothly, we believe these measures are still prudent. Today’s common market environment may prove to be (inaudible) bond, bond outflows have continued beyond at a slower pace, many hedge funds have suffered from negative performance, and as we approach the fall we may see redemptions from these hedge funds as well as we’re approaching the September Fed meeting. Rates may experience another bout of volatility. REITs and other market participants may elect to sell assets to reduce their exposure and to curtail their leverage. While Frank will go through our numbers in more thorough detail in a moment, I’d like to highlight a few of the metrics that reflect the action we took full turn in the second quarter and in the month of July. First, during the quarter, we reduced the size of the portfolio by 10% from roughly 5.1 billion to 4.5 billion. We have since further reduced the portfolio by approximately 15% as of July 31st. Our leverage now stands at approximate range of 4.7 times to 4.8 times our equity. Our current NIM is roughly in the same range as our NIM at the quarter end. In addition, we have added hedges in a very meaningful fashion going from 83% hedge ratio at the end of the first quarter to 134% hedge ratio as a percent of agency repo at the end of the second quarter. The average maturity profile of our hedges is also expanded in a meaningful fashion, moving from 4.61 years at the end of Q1 to closer to 5.4 years at the end of June 30. The additional hedges in the book are primarily the factor driving up our overall cost of funds to 1.84% at quarter end, versus 1.32% at the end of the first quarter. When taking into account our entire repo book including our credit portfolio our hedge ratio stood at 95% as of the quarter end. The rising interest rates negatively impacted credit spreads and the broader fixed income markets. Accordingly we thought it was prudent to layer in additional hedges, these additional hedges reflect the priority we place on risk management. As the events of the last few months unfolds we remain focused on managing the portfolio through market turbulence, as I mentioned earlier we believe more volatility is likely ahead of us and in accordance with our risk management philosophy we will continue to prioritize risk management and liquidity management, and book value preservation, even if it comes at expense of earnings. At the end of the quarter we were running a negative slight negative gap of 0.05 years on our duration. This represents a meaningful departure from the gaps we've won in prior quarters and again as reflective of our focus on risk management. On our earnings call last quarter I talked about how we had reduced our gap to 1.6 years to 1.3 years at the end of March. As I indicated earlier we want the portfolio to be positioned to withstand a greater range of interest rate market movements and therefore until we have clear visibility into what the new interest rate regime or range will look like we expect to maintain a very tight gap. We may open up this gap as we get more comfortable with the liquidity and profile of the interest rate market. Once we believe the transition path it's clear we will adjust accordingly. Finally in later part of the quarter we began a process of portfolio rotation within our agency book. After initially moving to substantially neutralize the existing portfolio from further shocks of higher interest rates, we have embarked upon repositioning of the book. Near term we envision a book that runs with more modest duration on the agency side, so you should expect to see us carry a less 30 year MBS than we have in the past several quarters and diversify into some shorter duration agencies including hybrid arms. Yields in the agency MBS market are generally more attractive than they were in prior quarters, and will be able to rotate our positions to better improve our duration in yield profiles. The credit book will continue to be a very important piece to the portfolio; we've spent a lot of time in the last few calls talking about our plans in the whole loan space. As David mentioned in his introductory remarks it's our intention to accelerate our move from agency MBS into loans both residential and commercial and we have been actively bidding and working to source assets. We continue to believe that MITTS shareholders will benefit from the Angelo Gordon credit platform including our ability to identify the most compelling assets on a risk adjusted relative return basis. Angelo Gordon's investment professionals remain engaged in the markets on a daily basis, and we're focused on identifying the best credit assets for MITT as we continue to build our presence in the whole loan markets. With that I will turn the call over to Frank.

[Frank Stadelmaier:]

Good morning. For the quarter we reported core earnings of 23.3 million or $0.83 per share versus 20.5 million or $0.75 per share in the prior quarter. The increase in core earnings was primarily the result of increased asset yields partially offset by higher cost of funds. Yield earned on assets during the quarter increased to 3.84% from 3.45% during the prior quarter. This was driven by two factors, the increase in our credit portfolio where yields are higher and the effective higher grades. As a percentage of total assets our credit portfolio increased from 26.5% to 31.8%. Also the yield on our agency portfolio increased from 2.84% to 3.02%. This was primarily the result of higher rates. We record revenue using a retrospective level yield methodology that considers a life time prepayment assumption. When rates rise prepayment tend to slow which results in higher effective yield for premium bonds. These higher yields also resulted in a positive $0.06 per share retrospective adjustment during the quarter which is included in core earnings. The higher yields earned on our portfolio were partially offset by higher funding cost. As Jonathon mentioned earlier the higher funding costs were primarily attributable to higher swap cost. During the quarter we added approximately 1 billion notional of interest rate swaps which increased weighted average cost of our swaps from 0.49% to 0.62%. Additionally the borrowings on our credit assets cost more than non-agency assets so this increase in size of the credit portfolio also increased funding cost. These factors contributed to an increase in our total funding cost from 1.27% last quarter to 1.46% this quarter. Finally the weighted average leverage used during the quarter was 5.47 times. Many of these steps we took around the portfolio and hedging occurred close to quarter end or post quarter end therefore the effects were not fully included in this quarter's earnings. To give you a better sense of our current portfolio I’d like highlight a few more statistics. The portfolio at June 30th had a net interest margin of 1.96%, the asset yield was 3.8% offset by repo and swap cost to 0.82% and 1.02% respectively for total cost of funds of 1.84%. Portfolio leverage was 5.4 times at 6

[Operator:]

(Operator Instructions). Our first question comes from Trevor Cranston from JMP Securities. Please go ahead.

[Trevor Cranston:]

I guess, first I just want to follow up on your comment that there have been further asset sales since the end of the quarter. Did that implied that the duration gap you show which is close to zero at June 30th. Has that gotten more negative if you’ve sold more assets and haven’t changed your hedges position materially?

[David Roberts:]

I would say, it's probably just a little bit more negative, we have reduced by maybe about $300 million, $400 million our hedges but it’s really been a commensurate with asset sales but we have definitely brought the duration down rotating out of 30s into shorter duration paper and at the same time we would taken off some of the hedges.

[Trevor Cranston:]

And did those numbers assume positive duration on your non-agency RMBS portfolio or do you think there is a significant positive duration in that portfolio.

[David Roberts:]

The duration gap we’re showing does not show positive duration for the credit assets. We undertook sales of assets that had the most positive duration in the credit book, we would attribute some positive duration to some credit assets to the portfolio but we’ve not included those in the numbers.

[Trevor Cranston:]

And then in terms of the whole loan opportunities, you’re seeing as you’ve kind of accelerate your transition, can you just talk about a little bit specifically about what you’re seeing both in the resi and the commercial space currently.

[David Roberts:]

On the residential side we’ve seen a material increase in sales of assets and we see from a relative value point of view, greater yield and whole loan versus non-agency securities, we see a pick up over a couple of hundred basis points in our relative value basis. On the commercial side, we really have a bolt-on strategy to our brick and motor business and there with our brick and motor team will see buildings that they would like to own, cannot own but we are able to lend to owners in either stretch first repositioning first lean, paper mezzanine credit that we think we can get very, very attractive risk adjusted deals in the high single digits, low double digits.

[Operator:]

Our next question comes from Joel Houck from Wells Fargo. Please go ahead.

[Joel Houck:]

Just a question on the strategy, it sounds like it’s more driven by the uncertainty and volatility in the current environment, given that rates have moved and the basis has already widened through July. It was seen implied that you guys remain cautious, concerned whatever adjective you want to insert between now and the year end. What exactly are you looking forward or I guess more directly, what would it take to get more net duration in the portfolio and maybe more exposed to entire basis? David Roberts I highlighted in my prepared comments that positioning of other fixed income investors was a big component of the sale off and the sharp widening in the basis the sharp widening or increase in interest rates, so I think we are looking in monitoring and we would like greater visibility into the positioning or possible behavior of other fixed income investors including other REITs. so that’s a big component and then I think we’re also looking for visibility into how the Fed may mix or change the composition of their bond purchase program which we will hope that we may have visibility in September. It appears the markets are priced in largely a taper currently in September but there is still quite a bit of uncertainly whether they will continue to keep the same proportions of treasury purchases, agency purchases. They did mention that they are apprehensive about misallocation of credit and so I think we need greater visibility to allow us to understand how much additional risk we should allow into portfolio.

[Joel Houck:]

Okay and then on the undistributed earnings, the $1.78 per share I mean that would seem to obviously going to have a lower core earnings power as long as you maintain its defensive positioning, should we assume that that is going to be used for the balance of the year to support the dividend and then will kind of reassess going in the next year based on the kind of a different portfolio positioning as we get through the taper and the new fed chairman?

[David Roberts:]

Its David Roberts, we don’t view that as supporting the dividend but just basically we’re looking at the undistributed earnings and complying with what we have to do in terms of distributing it and that can be somewhat of a moving target depending upon what happens in the portfolio overtime.

[Joel Houck:]

Okay and what’s the timeframe for when it has to be distributed? I appreciate that it can change.

[Unidentified Company Representative:]

Yes, it has to be out by the September 15th of next year.

[Operator:]

Our next question comes from Mike Widner from KBW. Please go ahead.

[Mike Widner:]

Let me just follow-up on Joules question there, I mean different companies have different ways of thinking about the requirements around the undistributed taxable with some having a preference for doing, kind of onetime dividends versus others demonstrating a preference that they rather sort of spread it out over the horizon, so how do you guys think about those two choices?

[David Roberts:]

I think, we spread it out historically in the past and we’d continue to do so. We still view it as somewhat cheap source of capital and I don’t think that changes for us.

[Mike Widner:]

I guess this thing I wrestle with here is this if I take the $1.78 and it has to be out, let say you’ve got four or maybe five quarters to spread it out over I mean that’s a pretty healthy chunk of change which is $0.45-ish or a little bit lower per quarter, which tells me you can cut the portfolio even more than you have and still kind of support $0.80 if you really wanted to, so I think that’s kind of what one of the things I wrestle with or we wrestle with and any thoughts on that or am I missing something in the math?

[David Roberts:]

I think the math is, it’s about $0.35 over the five quarters maybe a little higher than that but I think that’s right. It depends on really what happens in the two quarters also. We have the next two quarters earnings as well to factor in and the size of the portfolio will be one of the main factors in how much it generates.

[Mike Widner:]

So, you know, I really appreciate that you guys have done our jobs for us a little more than most, but if take kind of the guidance you gave and what you said, you’re telling me you’re kind 4-7, 4-8 times leveraged now and I think in your slide presentation and you verbal comments you kind of laid out the net interest spread and all that and it pretty clearly points that there is something around 10ish ROE and again am I missing something there or have you done my job for me?

[David Roberts:]

We would never say that we would do your job for you.

[Mike Widner:]

I wish you would. So, I guess the final question I have then is and I think you answered this, but I mean philosophically for all the reasons you laid out we’ve kind of gone from an environment where I think a lot of the market had a little more conviction about what was going to happen with regard to rates as well as Fed policy to one where I would say its complete wild card at this point, we don’t really have any idea who the Fed chairman is going to be, let alone you know whether that person feels any obligation to kind of quote rates lower versus let them run higher. And I am just not sure that that has any prospect of changing in the second half of the year given timing on Bernanke's departure and all that. So there is two ways you can kind of hedge away that risk and I think you guys seem to be doing a little bit of both of them, but one is to get yourself basically on paper a duration neutral position that may or may not be effective. Last quarter it wouldn't have been terribly effective because the base is widening and duration extension blah, blah, blah. And the other is obviously if you go to all cash then you don't have any book value risk at all, so de-levering and selling assets is another way to protect your book value. How do you think about, again you guys have sort of taken both of those approaches, right now you've pointed out that that has a negative impact on earnings. But how do you wrestle with it? you think you are comfortable now at this level and with the portfolio given the likely evolution and what might make you think one way or the other as we look at over the next six months.

[Unidentified Company Representative:]

I think there is a third component there, that we have really voiced even stronger our preference to move into whole loans or self-originated opportunities that we think will be more insulated from that action potentially, and most importantly the positioning of other participants in the markets. And so I think I will say that we will probably be very uncomfortable for the foreseeable future, we have been uncomfortable for several months, we have taken a series of actions even when we had conviction we increased our hedge ratio in the first quarter and even the fourth quarter, and we had quite a bit of conviction. Now I think we have a great deal of discomfort with the structure of the markets, and the uncertainty out of Washington. And so I think we have taken as you said steps to basically shrink the portfolio, we've taken steps on the interest rate side, we're not going to be able to escape the basis, but we can at least push more capital into assets that hopefully are away from the basis and we can insulate from rates and maybe insulate a little bit more from other market participants.

[Unidentified Analyst:]

So let me that one other asset class, you haven't mentioned which is investing capital in buying back your own stock which at the moment is trading somewhere right around 87% of book.

[Unidentified Company Representative:]

We look at everything all the time.

[Unidentified Analyst:]

So it's a contemplation but it sounds like you are not terribly committed, some have been more vocal about saying look we like the opportunity to buyback around stock when we are trading at substantial discounts to book. I not sure I am hearing that which I think is fine, but just looking for a comment.

[Unidentified Company Representative:]

I think you got the comment. You got the comment it's certainly something we're aware of and we look at it and everything that we do, we try to think not only about the immediate effect but also long term value creation as well.

[Unidentified Company Representative:]

We also think about when the issues stock, so you did not see us do an offering in the first half of this year

[Unidentified Analyst:]

No it was perplexing because you guys were trading above book for a while longer than a lot of guys. Well I don't know, that's where I think book way, but that was good discipline. And I guess I appreciate the comments and I think you probably said all you need about share repurchases.

[Operator:]

Our next question comes from Merrill Ross from Wunderlich Securities, please go ahead.

[Merrill Ross:]

At the end of the year, you announced that you hired a managing director and head of residential home loan platform. Is there any update as to how that business is progressing and any intention of creating flow relationships that would generate approval loans?

[Unidentified Company Representative:]

That business is progressing per plan we've added another individual to work with Jason Beagle, we anticipate that there would be future hires hopefully in the near term. We do anticipate at some point entering into flow arrangements, but the opportunity set that's immediately upon is legacy mortgages.

[Operator:]

We have no further questions at this time.

[David Roberts:]

Well thank you everyone for participating and we look forward to our next quarter's call. Thank you.

[Operator:]

Thank you ladies and gentleman, this concludes today's conference. Thank you for participating, you may now disconnect.