CMO
#Good morning.
Welcome, everyone.
I'll make a few brief comments, and then we'll open the call up to questions.
We reported EPS of $0.19 for the fourth quarter, up $0.06 from the third quarter.
About $0.04 of this earnings improvement is attributable to higher net interest margins as a result of higher cash yields on our 100% adjustable rate portfolio and a 13% decline in mortgage prepayment activity.
Together, these positives outpaced higher borrowing cost.
We also benefited from the passage of tax reform, recording about $0.02 in alternative minimum tax refunds at our largely dormant taxable REIT subsidiary.
Lastly, operating cost for our internally managed agency-only platform remained at industry-leading levels.
While earnings were much improved this quarter, book value declined $0.31 to $10.25 per share as declines in portfolio valuations exceeded increases in unrealized gains on interest-rate swap sales for hedging purposes.
This was largely a function of shorter interest ---+ shorter-term interest rates increasing considerably more than longer-term rates during the quarter, with 2-year treasury rates up 40 basis points while 10-year rates only increased 8.
Given this backdrop, our stock price has traded at a considerable discount to book value in recent months.
In response, we reactivated our $100 million stock repurchase program and repurchased $3.5 million in shares in November and another $10 million worth in January.
Together, approximately 1.5 million shares of our common stock was repurchased, over 1.6% of our outstanding shares.
These actions provided $0.01 of book value accretion in the fourth quarter and another $0.02 in 2018.
We may continue to repurchase shares in the coming months depending upon market conditions, including alternative capital investment opportunities.
Note that since year-end, 10-year Treasury rates were higher by over 30 points, outpacing increases in 2-year treasury rates.
Additionally, pricing for agency guarantee ARMs has been strong, such that thus far in 2018, changes in portfolio valuations had been relatively benign from a book value perspective and comparing quite favorably to portfolios containing a considerable amount of longer-duration ARM or fixed rate investments.
Regarding future earnings, with upward trending mortgage interest rates, we anticipate that mortgage refinancing activity in 2018 would be less of a factor than it has been in recent years, a potential positive for earnings.
Aside from this important earnings driver, 2018 quarterly earnings will largely be a function of how aggressive the Federal Reserve raises than the Fed Funds Rate.
With over half of our agency guaranteed ARM portfolio adjusting higher in coupon inside of the next 18 months, we should continue to see improving cash yields, allowing for the potential recovery of financing spreads reduced by higher borrowing rates.
For instance, as illustrated on the last page of our earnings press release, this currently resetting portion of our portfolio could reset higher in coupon by 50 basis points or so, based primarily on 6- and 12-month interest rate indices in effect at year end.
Importantly, these indices are considerably higher today than at year-end and should continue to increase with higher short-term rates.
In addition, we've held a sizable pay fixed receipt variable swap book that helps mitigate the impact of higher borrowing rates, particularly as it relates to the rest of our portfolio that consists primarily of ARMs that are scheduled to reset in rate in between 18 and 60 months.
In summary, our investment strategy of cost-effectively managing a leveraged portfolio of short-duration agency guaranteed residential ARM security, seeks to generate attractive risk-adjusted returns over the long term.
Key to our near-term success will be: Mortgage prepayment levels, the pace of future increases in short-term interest rates and the shape of the yield curve.
With that, I'll open the call up to questions.
Well, we'll have to look.
And as far as where we go long term, we'll have to evaluate that at the time.
And a lot it would be based on what we expect to be happening in the ensuing quarters and how we can use our capital.
The ---+ we bought back shares in November.
December, our share price recovered somewhat, we didn't really buy anything back.
And we did buy a lot of shares back in January.
And are quite surprised that our stock is weak right now.
We look at it from a trailing book value perspective, and obviously, what we can do with the capital at the time.
So we ---+ you can probably expect to see a fair amount of buybacks in the coming period if our price continues to be weak.
Sure.
If you look at generic space in January, they dropped another ---+ in the ARM portfolio anyway, they dropped another 5% or so from December.
We expect that to continue to trend down over the next couple of months.
And the low trench should be in March before they start recovering to some degree.
But like you said last year, we averaged around 24 CPR for the year.
We're looking for lower prints this year.
There are a couple of ---+ the burnout story on season-post resets has been valid.
Those bonds have dropped from the mid- to high 20s to the low 20s.
I would expect those, over the next several months, maybe to pick back up again.
There could be ---+ borrowers are now going reset us another 50 basis points, but the initial shock of resetting 125 basis points is not there anymore.
More of a story right now is our longer reset book, that if you look at it, we have about a 2.80% net coupon.
So those borrowers have about 3.5% mortgage rate, 5/1 now, with the increase in rates, are up to about 4 1/8%.
And the 30-year note cost is up to about 4 1/2%.
And so those borrowers, for the longest time, 5/1 rates hung around in the 3 3/8% to 3 5/8% range, and then fixed rates were in the high 3s to the 4-ish area.
And so those guys had incentive to refi in some cases, either at the new ARM or as a fixed-rate mortgage.
That's gone.
So if you look at the components of our book, you could easily see our longer-reset securities trend down to the mid-teens.
They were low to mid-20s last year.
And I would look post resets, and shorter resets, potentially being in the mid-20s area.
And so it kind of flip-flopped from where we were a year ago.
So hopefully, that answers your question.
That's a pretty plausible and realistic scenario, I think.
Well, if we're going to keep the leverage at the levels we're at, you're not going to see much future earnings improvement coming out of buyback, what you get is the book value accretion, and that's about it.
So if we can buy bonds at reasonable returns and the financing market allows for it such that we're not just redeploying capital from runoff, that will improve our earnings on return, obviously with the exposure of running a little bit higher leverage.
Whether we get there or not remains to be seen.
I think our duration gap moved out maybe 0.5 months or something like that.
A lot of that is just the inherent duration extension of our longer reset book.
Having said that, it is much more difficult right now to make a lot of sense of borrowing, for instance, 5/1s and swapping them out.
The spreads are fairly tight, and so we haven't lately done as much of that trade.
But we still are going to keep our duration gap fairly short.
I mean, still we went from, call it, just inside of 3 months to 3.4 months.
So I wouldn't look for it to drift much longer than that.
Sure, yes.
Since year-end, current market ARMs have tightened a decent amount, on a Z-spread basis, 7 or 8 Z.
And so far this year, they're trading shorter than their implied duration.
And so generically, 5/1s are down about 0.625 points right now.
Post resets are pretty much unchanged.
There's a strong bid for post reset paper.
And it's not uncommon in the first quarter to see ARMs tighten.
So they underperformed fixed rates in the fourth quarter.
So far, they're substantially outperforming fixed rates in the first quarter.
And also, supply is extremely low.
As the year curve flattened at the end of last year, originators weren't making as many ARMs.
And so you look at going from third quarter, where monthly volume was, say, $3 billion; and in the fourth quarter, monthly new issue volumes around $2 billion; in the first quarter, it's going to be significantly lower than that.
So a combination of the curve steepening, lack of supply and then underperformance of ARMs in the fourth quarter, has basically combined to cause it to perform very well in the first quarter this year.
In the first month of this year, I should say.
Well, you saw in the fourth quarter, for instance, short rates went up 40, 45 basis points and long rates only went up to 8.
And so ARMs ---+ ARM spreads didn't widen, but fixed rates tightened and ARMs spreads did ---+ so the bonds traded a little longer than you would expect them to.
So if you just extrapolate a scenario like that where, say, short rates went up 75 and long rates went up 10, that would be a very bad scenario for 5/1s, 7/1s, anything.
That would be a bad scenario 15-year passthroughs as well.
So I think the fourth quarter kind of gives you a snapshot of an environment that is not favorable for ARMs.
So just expand on that and make it a lot worse and I think you kind of get there.
