Armour 住宅房產信托 (ARR) 2014 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to ARMOUR Residential REIT Inc. third-quarter 2014 conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded Thursday, October 30, 2014.

By now, everyone should have access to ARMOUR's earnings release and Form 10-Q which can be found on ARMOUR's website.

Before we begin, I would like to remind everyone that this conference call may contain statements and, to the extent they are not recitations of historical facts, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of ARMOUR. Certain 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 ARMOUR's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's website at www.SEC.gov. All forward-looking statements that are included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless required by law.

Also, our discussion today may include references to certain non-GAAP measures. A reconciliation of these measures to the most comparable GAAP measure is included in our earnings release, which can be found on ARMOUR's website.

An online replay of this conference call will be available on ARMOUR's website and continue for one year.

I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead, sir.

Thank you, Kelly, and good morning everyone. I will now highlight some key financial figures for the quarter.

ARMOUR's Q3 GAAP net income was $0.14 per share. Core earnings and estimated taxable income were $0.13 per share. The primary differences are unrealized marked to market gains on interest rate hedge positions, which were $0.04 per share, and net realized losses on security sales, which were approximately $0.03 per share.

ARMOUR does not use hedge accounting for its book reporting purposes, so quarterly GAAP income will always be influenced, and sometimes even dominated, by the quarter-to-quarter fluctuation in fair value of our open swaps and other interest rate contracts. ARMOUR's REIT dividend requirement is based on ordinary taxable income. That excludes realized capital losses which will be available to offset future realized capital gains.

ARMOUR paid common stock monthly dividends of $0.05 per share in the third quarter and has declared monthly dividends of $0.05 per share for the fourth quarter of 2014. ARMOUR was the first mortgage REIT to pay dividends monthly. On a year-to-date basis, ARMOUR's common stock dividends are about $0.04 per share ahead of estimated taxable income. Final tax determinations will be made at the end of the year, but if interim trends hold, common stockholders will enjoy treating that portion of their 2014 dividends as a nontaxable return of capital.

At September 30, 2014 ARMOUR's book value was $4.58 per share. That's almost 19% above the New York Stock Exchange closing trade price on that day. Quarter-end leverage was 8.4 to 1, which includes the repo financing associated with $3 billion worth of portfolio security sales which are scheduled to settle in Q4. Repo availability remains strong across our 37 counterparties, and we continue to diversify our outstanding borrowings across both maturities and roll dates.

Liquidity consisting of cash and unpledged securities totaled $1 billion at quarter end. ARMOUR has $11 billion of interest rate swaps in place. The $3.45 billion of interest rate swaptions expired at the beginning of October. There are no immediate plans to replace them.

Now I'll turn the call over to Scott Ulm and Jeff Zimmer.

Thanks Jim. At the top here, I'd like to note that, in addition to the customary SEC filings, we also provide a monthly update which is furnished to the SEC and available on our website as well as EDGAR. The Company update contains a considerable amount of information about our portfolio hedging and financing on a timely basis.

We are now a year or more past the extreme bond market volatility of the summer and early fall of 2013, most popularly known as the taper tantrum. A year is a long span of time in the markets, but we feel that summer storm is almost doubling in a few months, marking the beginning of an inflection point in the markets. As the Fed now actually ends purchases of mortgage bonds, we feel the transition is well underway. And that impacts the way we have positioned ARMOUR's portfolio for this environment.

In short, we continue to feel that there is the potential for significant rate volatility as we transition from the unprecedented QE3 era to the new normal. We have prepared for that possibility in our portfolio, our hedging and our financing.

However, it's not just the end of QE3 that makes us cautious. We continue to feel that the US economy is recovering and that improvements will be reflected in interest rates. Since the inception of this Company, we have been in markets where every two steps forward in the economy seem to lead to one step back. While that environment still exists, it increasingly seems like only a half step back.

At the same time, we think the ultimate scale of rate changes is likely to be measured. We believe that the sort of hockey stick shaped increase in rates we experience 10 and 20 years ago are unlikely to repeat given the structural and other headwinds facing the US and world economy. Combine that with the current dubbish tone we hear from the Fed and the continuing issues in Europe and our overall outlook for the environment remains constructive. All of this leads to a specific perspective we have on risk and what it means for the way we construct and manage the portfolio.

In preparing for this call the other day, we estimated we've made more than 500 presentations to investors at conferences, individual meetings, and other venues. In all of those presentations, we have tried to deliver a consistent message. We seek to appropriately balance dividends versus protection of book value. But when push comes to shove, we will favor book value protection. And that is exactly what is behind the defensive positioning you see today in the portfolio selection, hedging, and financing.

The other way we can express this is our view that rate shifts have asymmetrical results in our business model. Volatile upward movements will likely require a reduction in portfolio size to keep leverage within a comfortable responsible range. It's difficult to regain that lost book value. On the other hand, downward volatility, if defensively positioned, can mean foregone but potentially temporary gains. We are okay with that trade-off. Let's discuss how these ideas are expressed in our portfolio hedging and funding. Jeff?

Good morning. This is Jeff Zimmer. So let's begin with portfolio selection. A quick look at our monthly updates from the beginning of the year will show a substantial position 30-year MBS. This spring, we sold our 30-years and reinvested primarily in 15- and 20-year paper. Our rationale was very straightforward. 15-year paper has less duration than 30-years and makes sense if we are headed for higher rates. The senior paper has larger regular amortization amounts leading to more reinvestment and therefore more opportunities to look and adjust to a changing environment. 15-year paper is easier to hedge with its shorter duration and thereby lowers the amount of capital we need to send away for the new higher swap haircuts. 15-year paper also will yield less than 30-year MBS, and we have been willing to make that trade-off given the lower risk.

We've maintained and effectively increased our hedge book since the taper tantrum volatility last year that Scott just spoke about. While we have reduced portfolio size over the last 15 months, we've maintained and even increased our swap position. You'll note from the monthly Company updates that approximately 90% of our REIT book financing is covered with swaps with a duration of negative 4 for a balance sheet duration of negative 0.3.

Of particular note is the amount of long 10-year duration swaps. This swap portfolio is considerably larger and longer than we have held in times we perceived as less volatile. From that perspective, it also represents a source of dry powder for earnings in calmer markets. That said, the amount and long tenure of the hedging are expensive and part of the trade-off of earnings versus book value protection.

The scale of our hedging did not allow us to participate in the recent rally in rates. We accept that because we are far more focused on the potential damage of a rapid spike upwards in rates and what could be temporary gains from a rally.

We should note here another source of risk in our business, spread risk, the variation in the value of MBS versus comparable tenure treasuries. Changes in spreads can move valuations significantly. In the third quarter for example, we estimate that 60% of our book value change was driven by spread and volatility changes. The good news is that spreads can widen and they can tighten. The bad news is that it is difficult and some would say almost impossible and uneconomic to hedge spread risk and we don't. It is also a major part of the risk we bear in order to earn our returns.

In the third quarter, 15-years widened considerably compared to the 30-year segment. Nonetheless, we like the risk characteristics of the 15-year pass-through securities.

As Jim noted, the financing environment remains favorable for our business. We continue to see wide availability in funding and a general actual improvement in pricing. ARMOUR now has MRAs with 37 counterparties and is currently active with 30 those. We continually seek to diversify our financing book, and as you can see on our monthly Company update, our counterparties range from large Wall Street firms to the European and Asian banks to regional securities and brokerage firms and some specialist finance companies.

But we do keep a close eye on our counterparties. While we are secure creditor to them, they are unsecured creditors to us with the haircut amounts and typically close to 5%. We've had numerous opportunities to extend our maturities recently through the year and beyond in some cases and once again you can note that on our monthly Company update. Depending on pricing, we have put some as longer financing on the books.

We are very pleased to have you as an audience today and will entertain any questions you have at this point. Operator?

(Operator Instructions). Douglas Harter, Credit Suisse.

Thanks. Can you just talk about whether you've had any sort of change in your philosophy, given kind when you started migrating to the 15s, the expectations were quite different for the magnitude of rate increases versus kind of where we are today. And sort of more concerned about the global economy.

Jim, I think what you're referring to is the fact that we started the year at a 3% 10-year note and everybody expected it to go higher. And we were at [1.84%] for a cup of coffee a week or two ago.

The thing to note is that we don't think the risk environment has changed, so we're going to continue to stay, for the most part, in our shorter maturity assets like the 15-year pass-throughs. We'll continue to maintain a large hedge book, and we will continue to put on the risk profile the importance of book value changes in the future.

Do you have a follow-up to that or have I addressed what you needed -- what you asked?

Right, but I guess while you've stressed book value performance in the interim, with rates declining, you have seen book value decline sort of greater than your peers in the interim. So, I guess how do you balance that for various outcomes?

As I noted in our comments, the book value decline in the third quarter, if you take a look at door 3s, they were down 23-plus%. I think the 30-year pass-throughs were down [2/32]. That's really the most of it. They actually tightened up a little bit since then despite the performance yesterday. So we will continue to stay in that asset class. It's got much less spread duration than the longer securities despite the fact that it has a tighter OAS.

Okay, thanks.

Trevor Cranston, JMP Securities.

Thanks. I guess kind of a bigger picture question on the portfolio construction. You guys kind of addressed the changing mix in the assets in your prepared comments. But I was curious. You guys have also talked about the increasing margin requirements on longer dated swaps in the past. So I was just curious if you could talk about do you still consider 30-years to be a significant part of the opportunity set, or given the increased cost of hedging, would you expect your portfolio to kind of more generically be focused on shorter duration securities going forward? Thanks.

30-years will always be part of the investments that we will take a look at. And as I just was saying to Doug, 30-year OAS's, if you look two or three weeks ago, looked very enticing. We just didn't want to add them and will not add in any big size right now to our portfolio, given the volatility in the marketplace. But you could see us a year for now or in 30 years, you could see us in a year and half from now owning a large amount of hybrids again if they start producing a lot, and if we think the risks are there. So the entire pass-through mortgage market is the oyster for us. It's just right now we are very comfortable owning the shorter final maturity pass-throughs with a less spread duration.

Got it. That's helpful. And a kind of more specific question, the monthly prepaid fee looks like kind of ticked up a little bit in the third quarter. I assume most of that is from seasonal increases. With the drop in rates since the end of the quarter, can you give us your outlook for prepaids over the balance of the year?

Let me address the third quarter and then I will address the future. When we sold the 30-years, most of that stuff was fairly new assets that were going to prepay fairly slowly. We know that 15-year borrowers generally are going to be a little more mobile, and we anticipated faster speeds on the 15-year assets and put those into our calculations of what we expected yields to be when we purchased all those assets. That being said, as you might have noted in our monthly Company update, I think about 63% of our 15-years have loan balances under $175,000 with a good portion those in the $85,000 to $115,000 bucket, so they can be fairly inelastic in terms of prepayments. Obviously prepayments are going to pick up here. You saw that applications were up 10% alone last week, so generally if that's the case you might see prepayments up 10%. So where would that take you? From 8% to 9% CPR, maybe even to 10%.

Great, makes sense. Thanks for the comments, and thanks for hosting the call.

Lucy Webster, Compass Point.

Good morning. I was wondering if you could talk a little bit about your leverage after the security sales settle. Are you thinking that it's probably going to normalize more around that 7.4% number that we saw in 2Q, or any color there would be helpful.

Yes, I do think that.

Great. And then just a housekeeping for me. The operating costs were a little below our estimates this quarter. I was wondering if that's a better run rate to use for 4Q or if we should -- what we should be thinking about the end of the year there.

I think if you look at second- to third-quarter variations in operating costs, one of the things to keep in mind, there is a little bit of seasonality associated with that. So second quarter is when we have our annual meeting and proxy solicitation and all of those sorts of things. So second quarter does tend to be seasonally a little bit higher. I think third is probably a little bit better predictor for fourth quarter.

Allright. Great. Thanks for taking my questions.

(Operator Instructions). David Walrod, Ladenburg.

Good morning guys. I just wanted to clarify a previous question. The leverage once the transaction settles will be south of 7. You're thinking though that you are going to add some assets and take it back up to the 7.5 times range?

Good morning. Yes, we would be targeting more towards 7 to 7.5 ultimately. At year-end it still could be in the mid 6s. We have various opportunities that we are looking at to invest, and whether they actually get settled before the end of the quarter or get settled in January is yet to be seen. We will know when it's the right time to reinvest and we will pull the trigger at that point in time. So don't expect us to stay down at that 6.5 level that is indicated in our monthly Company update.

Okay, thanks for the clarification.

Ken Bruce, Bank of America.

Good morning guys. This is Sean Summerlin on for Ken Bruce. Thanks for taking my question. Most my questions have actually been answered at this time, but I just want to ask kind of one strategy question. We've seen some of your peers rotate into non-agency RMBS, CMBS what have you. Have you guys considered trying to move in that direction at all, trying to hedge book value with some non-agency components?

Really not is the answer to that. As a bylaw of matter, we do have the ability to do things beyond agencies, but we've been in the agency market for five years. We've told a pretty consistent pure-play story in agencies, and it is very hard to imagine in the current environment that we would shift into a different strategy for ARMOUR. So, I think you can expect the asset type to remain consistent here.

Okay. Great, thanks.

(Operator Instructions). We have no further phone questions at this time. I will turn the call back over to you.

Thank you, everybody, for listening in on our Q3 2014 financial results call. We'll look forward to talking with you at the end of the next quarter, which will actually be the call on our 2014 K. Have a very good day and goodbye.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.