Armour 住宅房產信托 (ARR) 2014 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the ARMOUR Residential REIT, Inc. fourth quarter 2014 conference call. During the presentation all participants will be in a listen-only mode. (Operator Instructions). As a reminder, this conference is being recorded Wednesday, February 25th, 2015. For today's disclaimer, by now everyone should have access to ARMOUR's earnings release and Form 10-K which can be found on ARMOUR's website.

Before we begin, I would like to remind everyone that this conference call may contain statements that to the extent they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Private Security 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 different 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 these contained in the forward-looking statements are included in the risk factors sections 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 the 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 measures 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 Executive Officer. Please go ahead, sir.

Thank you, Benjamin. Good morning, everyone. ARMOUR's Q4 earnings and estimated taxable income were a positive $0.10 per share. GAAP results were a $0.41 per share loss which reflect our defensive positioning on interest rates and the attendant substantial overall negative duration we carried going into year-end. ARMOUR does not use hedge accounting for its GAAP reporting so quarterly results will always be influenced, or in this case even dominated, by fluctuations in the fair value of our open interest rate swaps. This quarter we had $185 million of those unrealized declines in value.

On the other hand, the quarter's $130 million positive mark-to-market on our agency securities flows directly into stockholders' equity rather than GAAP P&L. ARMOUR paid common stock monthly dividends of $0.05 per share in the fourth quarter. For all of 2014, ARMOUR's common stock dividends included about $0.09 per share of capital distributions, or nearly 15%, which are not taxable to the common shareholders. At December 31, 2014, ARMOUR's book value was $4.39 per share, or over 19% above the New York Stock Exchange closing trade price that day.

First quarter 2015 monthly dividends have been declared at $0.04 per share or an annualized yield of 10.9% plus on year-end book value. Quarter end leverage was 7.9 to 1 and our interest rate hedges covered 93.9% of our debt. Repo hair cuts and interest rates are holding steady. Availability remains strong and we continue to sign up new repo counterparties. Year-end liquidity consisting of cash and unpledged securities totaled $1 billion. Now, let me turn the call over to our Chief Executive Officers, Jeff Zimmer and Scott Ulm, to discuss ARMOUR's portfolio position and current strategy.

Good morning. It's Jeff.

We would also like to note that in addition to the customary SEC filings we also provide a monthly Company update which is furnished to the SEC and available on our website, www.ARMOURREIT.com as well as EDGAR. Company update contains a considerable amount of information about our portfolio, hedging, financing and on a timely basis. We are now a year and a half past extreme bond market volatility of the summer and early fall of 2013. We noted in our last conference call that we believe that the quick and dramatic rise in rates marked the beginning of an inflection point in the markets.

Over the course of 2014 we positioned ARMOUR's balance sheet to reflect that opinion through rotation out of 30-year MBS into shorter paper and the maintenance of a large swap book. As you have seen in our monthly Company updates since January 2014, through the present, our net balance sheet duration has ranged from a negative 0.46 to a positive 1.15 and is now a slightly positive 0.3. Our rates DVO1, or dollar value of a basis point shipped in the entire curve, is now approximately $500,000 and our spread duration of an 01 in OAS move is approximately $7.5 million, which does not incorporate the fact that swaps combined with mortgages making that number considerably smaller.

However, this very defensive posture did not produce outstanding income and outstanding book value enhancement in 2014 nor during the early part of 2015. The 10-year started 2014, as we know, at over 3%, and worked its way down to 2.17 at year-end. Since then the 10-year note has been as low as 1.64% and looks to be about 1.98% this morning, notably down since Federal Reserve Chairwoman Yellen's comments yesterday. We witnessed a bull market bond for the last fourteen months during a period where the ARMOUR balance sheet was prepared for the opposite.

The result is that we underearned and underperformed our peers in 2014. Our short duration assets which yield less than 30 year pass-throughs, along with our interest rate swaps with a negative 3.8 duration, covering almost 87% of our repo balances proved to be an ineffective strategy for the way the markets in 2014 played out. Book value at the end of 2014, as Jim said, was $4.39 and we have a book value today of approximately $4.20 to $4.28, an estimated range, with much of the change versus year-end coming from the recent OAS widening as a 10-year rally from 214 to 198 this morning. This book value is almost 26% above yesterday's closing stock price. That large gap encouraged us to buy back stock in the open market in the latter part of 2014.

We did not see any improvement in our stock performance from the repurchase. Whilst we were able to realize some book value accretion from purchasing at a discount, purchases in sufficient size to make this accretion material would also have adverse effects on the Company's liquidity and financial strength and perhaps even a negative reaction from our credit counterparties. Scott?

Thanks, Jeff. As you can see in our recent monthly Company update we have an almost zero balance sheet duration. Our portfolio is composed primarily of 15 and 20 year pass-throughs and Fannie Mae multi-family bonds or DUS, Delegated Underwriting and Servicing Bonds. Approximately 57% of ARMOUR's assets have pre-payment protection through low loan balances, high loan-to-value ratios, 60 months of seasoning or more, and pre-payment lockouts like in the case of the DUS bonds. We also have a 1.3 billion position of 30-year pass-through assets, representing 8.7% of the portfolio, consisting generally of high-coupon or seasoned high-coupon mortgages.

We are by design now currently learning less than our monthly dividend rate, all as a result of our large hedge position and our lower-yielding, lower duration assets. In 2014, approximately 16% of our dividend was a return of capital. This return of capital was generally in a period where ARMOUR's stock price was trading well under book value. As such, the return of capital was and is a non-taxable distribution at par value of our book providing some benefit for shareholders.

Over the course of the next few months we will modestly add higher yielding assets and slightly restructure the hedging book to increase our earnings. However, we will remain somewhat defensive until the posture from the Federal Reserve becomes clear. We continue to feel that the US economy is recovering and that improvement will be reflected in interest rates despite the similar environment overseas.

We have a positive view on the US economic environment but remain mindful of the multiple factors impeding more rapid economic expansion. At the same time we think the ultimate scale of rate changes is likely to be measured. We believe that the rapid, sustained increases in rates we experienced in the past are unlikely to repeat, given the structural and other headwinds facing the US and world economy.

Combine that with the measured tone we hear from the Fed and the continuing issues in Europe, and our overall outlook for the environment remains constructive. We have long maintained the view that we seek to balance earnings and book value protection. In this environment, we have put our figure on the scale to favor protecting book value from higher rates as a long-term goal.

We will be taking steps to increase earnings consistent with the rate environment and our view of volatility. You can expect, however, that we will remain relatively defensive. As we discussed in our last conference call we have maintained and effectively increased our hedge books since the volatility of 2013. While we have reduced portfolio size over the last 15 months we have maintained and even increased our swap position.

You will note from the monthly update that 87% of our repo financing is covered with swaps of a duration of -3.8. Of particular note is the amount of long tenured 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 (inaudible). We should note here, another source of risk in our business; spread risk, the variation in value of MBS versus comparable tendered treasuries.

Changes in spreads can move valuations significantly. For Q4 we estimated that most of our book value change was driven by spread and volatility changes. The good news is that spreads widen and tighten. The bad news is it is difficult, some would plainly say impossible and uneconomic to hedge spread risk. It is also a major part of the risks we bear in order to earn our returns. The financing environment remains favorable for our business.

We are seeing continued wide availability in funding and a general improvement in pricing. ARMOUR has MRAs with 40 counterparties and is currently active with 30 of those. We actively seek to diversify our financing book. Currently our counterparties range from big Wall Street securities firms, to large European and Asian banks, to regional securities firms and some specialists. The details can be found in our monthly Company update. We keep a close eye on our counterparties. While we're a secured creditor to them, they are unsecured creditors to us for our haircut amounts.

We have had numerous opportunities to extend our maturities to a year and beyond in some cases. Depending on pricing we put some of this longer financing on the books. We are pleased to have you as an audience today for our call and will entertain any questions you may have at this point.

(Operator Instructions). One moment, please, for our first question. (Operator Instructions). Our first question comes from the line of Trevor Cranston. Please proceed with your question.

Hi. Thanks. I guess first thing, I wanted to follow up on the comment towards the end of the call that you were planning to take steps to increase earnings going forward. Can you elaborate on that a little bit and talk about if the intention is to do that maybe through increasing leverage a little bit or changing around the hedge book some? Thanks.

Good morning, Trevor. It's Jeff. You wouldn't expect this increase to leverage much at all. It would be by adjusting the hedge book a little bit. Which we have already pro-forma'd this and when we get more comfortable we can do it very simply without great long-term effect to the capital position. And we might increase as we become available, finding some of the seasoned higher coupon 30-year paper which yields quite a bit more than the 15-year paper and has a really good OAS.

It's a combination of a number of things and it has to happen on a kind of iterative basis over a period of time.

Okay. Got it. And within the portfolio construction, the agency multi-family book has been growing a little bit recently. Can you talk about how you view the returns on that -- those securities versus 15's to 30's and why you find them attractive?

Sure, the yield two-thirds of the way between 15 and 30-year securities and at some point in time they can almost yield equal to 30-year pass-throughs. What's great about that asset class is because you have a defined maturity, usually a 6-month window at the end, it rolls down the curve like a government bond or even a corporate bond. And so over time, it will trade at a tighter Z-curve.

So you can actually get book value accretion out of that asset class and it becomes easy to hedge because it's a normalized roll down the curve, rather than the mortgage bond which is quite elastic in its pre-payments capacities.

Okay. So when you guys are kind of looking at the environment today, would you expect that bucket to continue growing versus the 15's and 30's?

I wouldn't expect that bucket to grow more than 2% or 3%, max. That's something we have been discussing over the last couple of months. It's opportunistic as well. When the sector widens out, it can be in the mid to low 50 kind of Z-spread. That's perhaps an opportunity. When it gets a little tighter, we don't have an interest. Mark, any more comments on that?

Swap spreads.

Swap spreads -- versus swaps. 52 versus swaps, not Z, excuse me.

Okay. Thanks for the comments.

Thanks, Trevor.

Our next question comes from the line of Mike Widmer. Please proceed with your question.

Hey, good morning, guys. Thanks for the good disclosures as always. Definitely appreciate you guys giving the update on book value quarter to date. I mean, it seems like it's moved around a bit. We have had a pretty volatile environment. So first, I just wanted to say thanks for all the very clear disclosures. I guess my question is, you guys laid out, I think, the post mortem of what's happened pretty well, and it's been -- I think you highlighted, a lot of swaps at the longer end of the curve have seen pretty substantial declines in value and the curve has sort of flattened out already as the long ends come down.

Quarter to date it's been a little bit -- we have had a continuation of that sort of rollercoaster. How do you guys think about that? And then I guess my real question is; You're positioned to basically benefit, and correct me if I'm wrong here, but your book value is positioned to basically benefit if the curve steepens up or if the long end rises but that's where your exposure is if the curve sort of flattens out further. Is that sort of intentional? Is that where you want to be? Or is that something you might seek to adjust? Jeff, I think you had talked about adjusting the portfolio going forward.

Good morning, Michael. First of all, I thought your report that you put out this morning was very thoughtful, with a very clear understanding of where we are and where we stand. So I appreciate that very much. Regarding your question, I think the answer I gave to Trevor is probably the same answer that I would give to you; We did believe we would get a steeper curve, despite what is going on over in Europe, which creates a little bit of an anchor for the 10-year note. Part of that was because we do believe there's a lot of inherent leverage in the system and that at the first sign of some disruption in the short end, you might have a round or two rounds of selling.

Maybe not similar to the June/July period in 2013 but something of that regard. It is our intention, the longer time goes on, if that does not occur, to once again, as I said to Trevor, modestly move the swap book around and get the asset class that will yield a little bit more but also doesn't have a lot of duration to it. When you get into the season, higher coupon 30-year pass-throughs, they're at the higher end of what we call the mortgage S-curve. You've got to have a big move in rates for the prices on those and the quality of the duration cling on those to change. I hope that's helpful.

Yes, it is. It is. I appreciate that. I guess one other thing -- thinking about those kind of the swaps that are sitting sort of, I guess, 8 to 10-year bucket right now, they line up pretty well with the multi-family loans you've got, which I think you talked about a little bit. I see you increased the position in there a little bit. I don't know that market that well. Are those liquid enough to sort of put more on when you want to reduce sensitivity, if you will? You know, thinking about using those and basically balancing out the hedges, and then potentially taking them off --?

Are you asking greater certainty? Right. Are you asking if these swaps are liquid or if the DUS are liquid?

Well, no, no, more the DUS, yes.

Yes, the DUS are actually quite liquid. Fannie Mae has a large program, so does Freddie Mac, where they actually take these and they put them into CMOs. There are periods where they are more aggressive, wanting to buy these assets and periods where they are less aggressive. Another way we could get liquidity in these, quite frankly, is to put them in a CMO ourselves and sell off some of the cash flows and retain some of the other cash flows which we have modeled out as well. Yes, we feel very good about that asset class and what we could do. However, I can't make one phone call and sell a billion of them. It's a couple of day's work. Unlike a Fannie Mae 30-year pass-through three, I could sell right away.

Yes, yes. All right, well, listen. I appreciate the comments as always, guys. Good luck. It's a tough interest rate environment out there.

Thank you, Michael.

Our next question comes from the line of Douglas Harter. Please proceed with your question.

Thanks. I was wondering if you guys -- again, appreciate the candor on what happened last year -- I guess as you guys are reviewing that and planning for 2015, if you've changed any of the risk tolerances around rate moves, rate sensitivities as you look to make some of the portfolio changes that you guys are looking at, to narrow the band of outcomes?

Yes. Consistent with what I've said to the last two analysts, Douglas, we will be making some modest changes. They won't happen in a fortnight. It is going to take another month or so. We're being very cognizant of what's coming out of the Fed and how the markets are reacting. But most of all, as I said, they will be iterative. So we move a little bit of the 10-year swaps into the 5-year sector. We've got a little hole in the 7-year sector. These can be done over time and without much subsequence to how the balance sheet looks.

We can move out of some of the 15-year assets which are actually yielding quite a bit. Although on an OAS basis they're kind of cheap at 30 years right now so we're not really pumped up about selling those to go into some of the seasoned 30-year paper. So this will happen as spreads move and the opportunities exist themselves. But we will not maintain at ARMOUR the negative duration, large duration balance sheet that you saw during parts of 2014. That strategy didn't pay off, but will be flat enough so that as interest rates move up, and usually in that case we get tightening OAS, you can actually get book value performance. That's how we look at it. I hope that's helpful.

Great. I appreciate it. Thanks.

Great. Have a good day.

Our next question comes from the line of David Walrod. Please proceed with your question.

Good morning, guys. Just wanted to -- I know we've talked a lot about the swap book and about tinkering with it. The amount that you have hedged has declined from the end of the fourth quarter through your most recent update. Would you view that the absolute amount that you're hedging would go down as well, or just more tinkering with the composition of the book?

You might see the absolute amount go down a little bit, particularly if we decide to re-enter the hybrid market. We have been watching that. It's actually cheapened up a little bit, and I know you have heard that from some other people. We haven't positioned ourselves to enter right now. But if we do get into some of the short asset class that doesn't require as much hedging, that would bring it down. Additionally, when we look at the seasoned 30-year paper, David, the duration on that asset is very low, even though at this point some of the stuff 60 months old revised to get 25-year finals, and it does have extension risk up 75 to 100 basis points.

But between here and then, it doesn't. That might require a little bit of a shorter book or a little bit less hedging. But you wouldn't look for a 10% or 12% move in the amount of hedge.

Okay. That's helpful. Jeff, you've commented about the buyback. You did some in 2014. Sounds like you're not viewing that as something you would do with 2015. Is that -- I mean, is there, theoretically, I guess, a price level where you would say; We just have to do it because it's so accretive to book, or for some of the other reasons that you outlined, it's just not something you're really considering?

Yes, David, it's Scott. Yes, look, we always look at buybacks. We have an extent authorization of some size here. So we continually look at it. To us, it's a straightforward question of accretion, in book value that's available as a function of the discount that you might realize, versus reducing the size of the Company, our financial flexibility, and our liquidity. And I can't establish precise bounds on what those numbers mean. But that's clearly the trade-off. Frankly, the disappointment has been that we really have not seen the trading performance improve as a result of a buyback execution per say.

That leaves really just the accretion to be compared flat up against the other sort of broader corporate finance factors. And you know, look, we get a sense from a lot of market participants that they're not particularly enthused about us getting significantly smaller. And by that I mean none only people on the common side book, it includes credit counterparties and others as well. So, look, we balance it. We look at it continuously. And we have executed over the last several years, but it's always going to be weighed against those two factors.

Okay. Thank you.

Thanks, David.

Our next question comes from the line of Brock Vandervliet. Please proceed with your question.

Great. Thanks for taking my question. Let's see, if you could just talk about your basis risk or mortgage spread expectations for the 15 and the 30-year product? And then I had a follow-up.

On OAS basis, as I indicated at one or two calls ago, 15-years still look fairly cheap versus 30-years. I apologize. They had cheapened up versus 30-years. We are not -- as a result not wanting to sell 15-years right now. There will be a point at which those OASs change their spread relationship and we would sell some 15-years to buy some 30-years. On an actual price performance basis they have of course done well because the markets rallied here. Okay, so that's number one. By the way, number two, thank you very much for initiating coverage on us last month.

We appreciated your read. In terms of where we would go next has, I think, been fully discussed with the four or five other calls that we have had, the amount of our book that is covered in terms of pre-payment protection is closer to 60% than not. We'll continue to buy those kind of assets. We'll continue to watch OAS and see where the values are. And we'll continue to monitor and work on our hedge position, which we have indicated a couple of times, we are going to do some slow but iterative remodeling of to keep our duration flat to positive. But also so we could benefit if we get a spread tightening.

Now, the two or three times we've ran back to 210, 215 on the 10-year note, mortgage spreads have done very well and tightened. We're already through five months past the Fed quitting buying, and mortgages right now actually on a just pure OAS basis look fair value. I would expect that if rates go up, our opinion is that we'll actually see some tightening, unless you get a major rate move and a vastly negative reaction to Fed comments, which means you could have an unlevering situation, where in those sell offs, like a little bit like summer 2015, you would have a temporary, could last a couple of weeks to a month of a broad widening. Those are your two outcomes. On a normalized basis, though, we would spread in a slow move up in rate spreads to tighten a little bit. However, once again, if you have an awkward thing like summer 2013, you're going to have some spread widening and it could be quick and ugly. Does that answer your -- and approach your question?

Yes, that's great especially the forward look there. If you could also just talk about the spread level, I believe it was 127 for the quarter. What should we be looking here going forward?

Well, our NIM will -- can increase by two ways. First of all our financing rate is not going to change for a while. We have -- forward guidance, unless LIBOR goes up or Fed funds go up real quick. So let's assume the financing stays the same. Let's assume to some extent we re-engineer our hedge book slightly, which would mean that the cost of hedges could come down modestly. And let's assume that we take some of our higher yield -- lower yielding paper and swap that into some slightly higher yielding paper over time, you would have that NIM expand.

I can't give you exactly what number that will be. But our goal is to be earning the $0.04 a month that we want to generate, and off a -- so you would be generating off of a $4.30 book value, and an ROE of 10.5, give or take.

Okay. Thank you.

Okay, thanks.

Our next question comes from the line of Mark DeVries. Please proceed with your question.

Thanks. I have a follow-up question on capital returns here. I think, Scott, as you pointed out, the dividend here is above the core earnings run rate. Can you just talk about how you're thinking about that, the logic of keeping it there, particularly when the market doesn't seem to be rewarding your stock for that dividend level?

One of the things Jim Mountain briefly discussed in his comments, Mark, is the fact that if we return, if we're -- say you're earning $0.03 -- and we're not earning exactly that and I can't comment on that -- but whatever we're earning and we're paying out a little bit more, that extra penny or so comes back to shareholders in theory at book value. So if you were trading -- a stock trading above book value, that would not be a very good strategy. But if you're trading below book value and were generating free cash to them that's non-taxable backed at book value, honestly it's a pretty good thing to shareholders.

We have been on the road two of the last three weeks, meeting with some of the our different bankers, and we all agree mathematically that that's a sound analysis of what's going on there. However, we also agree with you that the stock market is not rewarding us for our under performance in earnings and they did not reward us for our under performance in book value last year. So we're very cognizant of it. That's why the iterative changes that we just have discussed for the last 30 minutes will take effect.

It has not been brought up in a recent Board meeting about cutting the dividend. However, we do have Board calls every month and another formal meeting in April and we'll take a good look at it.

Got it, thanks. That's it for me.

Okay, great. Thank you very much.

(Operator Instructions). Our next question comes from the line of Lucy Webster. Please proceed with your question.

Hey, thanks. My questions were actually asked and answered. Thanks.

Thank you.

Our next question comes from the line of Richard Eckhart. Please proceed with your question.

Actually, the first caller addressed all of my questions. Thank you.

Thank you, Richard.

We have no further questions from the phone lines at this time.

We look forward to speaking with all of you at the -- when the results of the first quarter are released. However, we are always open to calls. We are traveling in New York quite a bit, or wherever you may be stationed, it's likely that wherever you are, we're perhaps there a couple of times a year.

So please reach out with questions, before you issue any reports, if you have any concerns that you just want to understand or straighten some thoughts out, please call any of us. We'll help you the best we can. Once again, Operator, thank you very much. We're done.

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.