Armour 住宅房產信托 (ARR) 2015 Q4 法說會逐字稿

Welcome to the ARMOUR Residential REIT fourth-quarter 2015 earnings call.

(Operator Instructions)

As a reminder, this conference is being recorded Friday, February 19, 2016. I would now like to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead.

Thank you operator. Thank you all for joining ARMOUR's fourth-quarter 2015 earnings call. By now everyone has access to ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website. This conference call may contain statements that are not recitations of historical fact and therefore, 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 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 ARMOUR's website and at the SEC's website, www.sec.gov.

All forward-looking statements 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 to do so 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 at ARMOUR's website. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for one year.

ARMOUR's Q4 core earnings were $47.7 million, or $1.10 per common share. That represents an annualized return on equity of 13.4% based on book value at the beginning of the quarter. GAAP net income was $117.8 million, or $2.88 per common share. These two measures differ mostly due to unrealized gains on our interest-rate derivatives. ARMOUR does not use hedge accounting for its GAAP reporting. As we've seen in prior quarters, fluctuations in fair value of our open interest rate swaps remains the dominant factor in GAAP P&L, while the inversely related marked-to-market on our agency securities flows directly into stockholders' equity.

At December 31, 2015, ARMOUR book value was $28 per share, or more than 28% above the New York Stock Exchange closing trade price that day. Year-end book value includes $1.13 of accretion from the ARR common share repurchases throughout the year. Between share repurchases and the tax-free portion of our dividends, ARMOUR has returned nearly $200 million of capital to common shareholders in 2015. We paid monthly common dividends of $0.33 per share for the fourth quarter and have continued that rate for January and February. Quarter-end balance sheet leverage stood at 9.44 to 1 and liquidity totaled approximately $641 million. Our captive insurance subsidiary has a $100 million FHLB member advance which matures in December 2016.

We were disappointed by the recent final regulation that requires captive insurance companies to exit the FHLB system. We continue to believe that mortgage REITs like ARMOUR and their captive insurance subsidiaries share an important common mission with the FHLB system, financing American homes with private capital. Now, I will turn the call over to our Co-Chief Executive Officers Jeff Zimmer, and Scott Ulm, to discuss ARMOUR's portfolio position and current strategy.

Good morning everyone. In additional to the customary SEC filings, we also provided a monthly Company update which is furnished to the SEC and available on our website as well as EDGAR, www.armourreit.com. The Company update contains a considerable amount of information about our portfolio, our hedging and financing on a timely basis.

As result, the 2015 Annual Financial Report that we filed last night should contain no surprises to any of our equity analysts or shareholders. We are pleased that our fourth-quarter core income exceeded dividends paid. We are displeased book value was down a bit more than the average over the REITs in our peer group.

Book value decline was primarily due to the mortgage investment environment in the fourth quarter which was dominated by widening spreads, volatility in the longer end of the yield curve and of course, the long, anticipated increase in short-term rates by the Federal Reserve.

These high volatility trends have continued into the new year, with a 10-year note yield bottoming at 1.53% intra-day last week after being as high as 2.34% at one point in Q4 as spreads remaining wide net of the substantial uptick in yield and compressions that occurred in the last few sessions. The 10-year note rally from 2.27% at year end through the $1.53 print last week reduced our year-end net duration of 0.21 to negative 0.55 as of two days ago.

This duration shortening, along with the spread widening, has negatively impacted book value in Q1 2016. As of our late January 2016 monthly Company update, book value was down 4.4% from the end of 2015. More information on our current estimate of book value will be available on our monthly Company update, which of course, will come out later in the month.

The rates DV01, or the dollar value of a basis point shift in the entire curve, is now approximately negative $652,000 which is below the year-end number which was positive $261,000. Spread duration of about $6 million is just slightly lower than last quarter. We have not made any significant asset or liability changes this quarter and we remain quite liquid, with our all-in liquidity position being approximately $497 million as of this morning.

As you all are aware from our January 7 announcement, we were very active purchasing ARMOUR stock in the open market in 2015, and particularly in the fourth quarter. We spent approximately $159.6 million repurchasing common shares, or 17% of our outstanding shares in 2015. We have nearly 1.9 million shares left in the current buyback authority and if needed, the Board can also increase that at any given point in time and I'm sure it will be a point of discussion down the road. We will continue to utilize share repurchases in the future, assuming the deep discount to book value exists and our purchases are accretive. The scale of our share repurchases has pushed our leverage a bit over our target levels and we expect this will revert to usual levels as we modestly rebalance the portfolio.

We have not yet repurchased any shares in Q1 2016, as we wish to remain exceptionally liquid during this volatile period. As Jim Mountain noted in his opening comments, we returned almost $200 million to shareholders in 2015 through the stock repurchases or non-taxable dividends. Once again, all this information can be found on the monthly Company update.

Now, the portfolio today is very much like it was at the end of the third quarter and is comprised of five major components. 35% of our portfolio is comprised of 15-year pass-throughs, of which 84% of those have loan balances less than $175,000, great convex assets. 32.5% of our portfolio is comprised of 20-year fixed-rate assets, maturing between 181 months and 240 months, with a weighted average seasoning of 60 months. The seasoning also provides great convexity to those asset class.

18% of our portfolio is comprised of Fannie Mae multi-family bonds, or DUS, which is Delegated Underwriting and Servicing bonds, which are generally locked out from prepayments for the first 9.5 years of their 10-year expected maturity. Now that portfolio right now has 8.6-year average weighted maturity and what's great about that asset class, as it rolls down the curve, it will trade tighter to the underlying [treasuries].

11.8% of our portfolio is comprised of 30-year maturity fixed-rates, of which 97% of those are $175,000 loan balance or less. Once again, great convex assets. The balance of the portfolio are small positions in some shorter fixed-rate paper ARMs and Hybrids. We have exited the dollar-roll transaction. The dollar-roll, which was on special much of last year is no longer special in the coupons that are of interest to us which most of last year was the Fannie, 3.5% 30-year [past years].

As I said, this portfolio has a lot of very convex assets and we expect it to provide good price performance in a rate rally and a limited amount of extension in a higher rate environment. However, we have seen an uncharacteristic lack of interest in the convex assets during the Q1 2016 rates rally. We took a look this week at what pay-ups were for convex assets, such as low, loan-balance mortgages when rates were similar in 2012. And we found that on average, the prices paid at that time were approximately 5/8 of a point more over TBAs than they trade today. Of course, noteworthy at that period, though, was the fact that rates had been low for a longer period of time.

We are most interested to see how this asset class does if rates stay low for awhile [or] prepayments start to pick up for the non-low-balance paper. Our guess is that this asset class will perform quite well in that scenario. You all can do the method but 5/8 of a point increase in the pay-ups for that asset class will be a substantial book-value increase for ARMOUR.

Our core earnings of $1.10 a share exceeded dividends paid of $0.99 in the fourth quarter. We have continued a monthly dividend rate of $0.33 per share so far this year, though we expect earnings in the first few months will be well below that level due to the higher funding costs versus Q4 2015 and the end of our dollar-roll transactions, which have had a great income for ARMOUR over the last couple quarters.

Now I'm looking at a chart right now that has a list of all the agency REITs that the analyst peer group provide for us and the average earnings for those REITs, off of their book value, is actually 10.8%. There is one high outlier and if you take that out, it's 10.3%. So ARMOUR at $0.33 a month is actually at 14.1%, considerably higher than the group. And at some point, I think we and the Board think that we're not getting paid for that because our price-to-book ratio seems to be average with the group. So it would be noteworthy of that thing and I think you're all aware of it but yet I don't see a -- we have been receiving no phone calls or questions on that at all so take a look at that and you can expect that we will be closer to average, I think, down the road.

Now, other than the exit of the dollar-roll, which if we restarted today, would provide no pick-up in earnings. The general composition of the portfolio, as we indicated, did not change significantly in the last quarter. We reduced our [notional] swap position by terminating some current pay swaps and have some forward-start swaps that have become current pay. Today, 49% of our REPO financing is covered with approximately $5.6 billion of current pay swaps. In addition, our forward-start swaps position has declined 51% to $3.15 billion. Our entire swap book has a duration of negative 4.6, the size and tenure of our hedge book is expensive, as we've told you before, and the trade-off of earnings versus book value protection of that not so much during this recent [dramatic] rate move and spread-widening move. In periods where we perceive less rate risk, we would carry significant smaller and less expensive swap book.

The financing environment remains favorable for our business, although at the end of Q4, REPO rates were higher, mostly reflecting the Fed's tightening move in December. While some folks told us they wanted a smaller REPO book at the end of the quarter, we continue to see wide availability of funding. ARMOUR has MRAs of 38 counterparties and is currently actively with 26 of those. We believe the Federal Home Loan Bank's regulators' decision to force captive insurers to exit the system is unfortunate and is not consistent with both practice and statute. As Jim indicated, we have $100 million outstanding with our Des Moines Federal Home Loan Bank membership and that does not mature until December of 2016.

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 some regional firms and specialists. And once again, details can be found in the January monthly Company update which lists explicitly who we are borrowing from and how much. We also keep a close eye on our counterparties. While we are a secure creditor to them, they are unsecured creditors to us for our haircut amounts.

We've had numerous opportunities to extend our maturities to a year and beyond in some cases and we have done some of it; putting some of this longer financing on the book, just depends on the pricings. New counterparties and new structures being shown to us, also a promise for additional compelling sources of portfolio financing. That would include direct REPO and actually doing directly with Federal Home Loan Banks out of the system. You can see that if you look at our borrowers' list on the monthly Company update.

As we stated in our comments last quarter, we continue to feel the US economy is recovering and that improvement will eventually be reflected in the interest rates despite dissimilar environments overseas. We believe the weakness in the global economy will clearly restrain the range of US interest rates over this year.

That said, we are mindful of volatility, as so clearly demonstrated in the recent large 10-year Treasury move. We are pleased to have you as an audience today and we look forward to any questions you have. Please feel free to have questions. Operator?

(Operator Instructions)

Douglas Harter, Credit Suisse.

Based on the monthly updates and where the share count ended, it looks like you guys were quite active in the last 10 days or so of the year in terms of buyback. Just wondering if there was any color you could give around that?

I think we indicated on our last earnings call, and if we didn't, it is okay to talk about it now. We had been buying modest amounts and we found that the -- we did a report that showed how much our peer group's prices have changed versus us on the days that we were buying back.

And we found that when we were buying back modest or medium amounts, there wasn't much change. In other words, at one point, our performance was 0.1% worth than the peer group on days that we were buying back. So we decided to try a new approach and we increased, for a period of time, the maximum amount of buybacks allowed under the rules and we got better results from that. So that, you will see the last part of the last quarter is when we put that new program in.

Got it. With the leverage moving up to come into the 9s, and with the volatile period, can you talk about how high you would be willing to let that leverage go on a -- in periods of volatility?

So two things happened. Obviously, with the buybacks at the end of fourth quarter, leverage naturally goes up unless you start selling assets and unwinding swaps. We did not reinvest paydowns for the last couple -- actually, I think, three months to solve part of that problem. As the book value has gone down in the first quarter, the leverage naturally goes up and if it stays here at that level for a little while longer, you will see us go ahead and sell some assets and unwind some swaps. That is the type of thing we look at every single day and I think we naturally like to see our leverage closer to 9, if not below and that -- as we've said in the last earnings call, it would be our goal.

Okay, thank you.

Trevor Cranston, JMP Securities.

Thanks. You guys mentioned in the prepared remarks a little bit about the change in the net duration since the end of the year and the decline in book value. Was wondering if you could talk a little bit about how you think about the construction of the hedge book with rates down where they are today? And potentially how you would manage that in terms of the duration of some of your swaps if we were to see a further rally in rates? Thanks.

Good morning. So at the end of the year, we had a 0.21 duration and our goal was to manage at a just slightly positive duration. The move over the first six weeks of the year was dramatic, particularly the first eight trading days of February and what we don't want to do is the 2013 scenario, that so many firms found themselves in, is unwinding and selling at exactly the wrong time.

Okay, mortgage spreads have widened quite a bit over a four-, five-day period there. Things have settled down now and you would expect us, at some point, to modestly over time and not necessarily by the end of the quarter reduce some of that duration exposure on the longer end.

Okay. Got it. Thank you.

David Walrod, Ladenburg Thalmann.

Good morning, everyone.

Hi David.

I noticed in your January update that your prepaids ticked up a little bit in January. Can you give us a sense of where they came in, in February?

Well, the monthly company update is not out yet but there was no significant change because I haven't released it yet. I wouldn't want to talk -- it was very, very close to what they were before. If anything, they might even be down a little bit.

And then --

David, if you look at the convexity of our portfolio, and I discussed it at length in the prepare remarks, it's going to be very hard for us to see a dramatic jump in prepayments, at least how we're structured right now. A majority of our non-20-year assets have some low balance component to them and our 20-year assets have five years of seasoning on them which provides convexity as well.

So if you see TBAs go up to 22% CPR, I don't think you're going to see ours jump from 8% to15%, okay? You're not going to see a jump like that.

Right. And I just wanted to clarify, Jeff, in your prepared remarks, you talked about the current run rate of earnings. Would you say they are below what you printed in the fourth quarter or below the dividend?

We are earning less than we were living -- earning -- pardon me, we are earning less now than we earned per month in the fourth quarter. And we are not quite earning the dividend that we are paying out right now. So more directly, we have returned some capital, if you want to look on a monthly basis in January and February.

There's two ways to approach being very favorable to shareholders. You can do stock buybacks, which we were effective last quarter in doing, as you know, or you can pay back in dividend where actually a shareholder gets money back at par, and that we have done that so far in the first quarter. When the earnings come out, we will be more explicit on that and the numbers aren't certainly yet defined yet because we are still in the middle of February.

Okay, thank you.

Chris Testa with National Securities Corporation.

Good morning. Thanks for taking my questions. Just with the multi-family book down slightly quarter over quarter, were you harvesting gains there? And in the current pricing what you see now, is that something you find attractive to do more purchases of this quarter and next?

We said a couple of quarters ago when somebody asked a question that somewhere around 18% to 20% would probably be the max we would want to have of any asset class. And so we are in that range right now. It is really attractive but so are a lot of other asset classes. Now, as I said, the dollar roll doesn't look very good right now, but the OAS is on 30 or [3.5] have widened up considerably here.

And I'm looking at a chart internally and we are within a short putt of where the wides of those are. The one thing about the DUS that we love, as I said earlier, is that it rolls down the curve like a Treasury note and as it gets shorter and shorter, it tightens and tightens, but we don't want to own too much of the asset class.

So I would expect that you wouldn't see us buy too much more of it unless for some reason, the equity base got bigger. We did sell a piece or two earlier this year, it was a very small piece, and we did have some gains in that but I don't -- I think it's insignificant to the entire structure.

One other thing -- this is Mark Gruber. One other thing we have to -- you have to be careful about with DUS is that because of the prepayment lock-out, we don't want to have a giant portfolio of stuff that doesn't pay down at all. No reinvestment, and no -- you don't have to worry about cash flows.

Right. That makes sense. Just -- sorry -- (multiple speakers)

One of the things is -- the thing about regular pass-throughs is you do get free cash flow every month. So I think we had $150 million of prepays in January so we chose not to reinvest that amount. So it does give you more optionality if you have -- if a good portion of your portfolio has monthly regular cash flows. Back to you.

Okay. And just with the buybacks, again, I know you talked about 1.9 million shares left of you could repurchase, but what are thoughts on this getting the authorization being increased in the near future, assuming that the stock continues to trade at a 30%-plus discount the book, like it has?

I would say that within a few Board meetings, the Board, including us, would recommend that we have the ability to buyback and we would increase it.

I think -- it's Scott Ulm. I think it's fair to say that we will always have authority to buyback stock that is more than sufficient for what we are planning to do. And look, this was a compelling case last quarter and it very well may be again over the course of this year so I don't think Board authorization is -- could at all be the barrier to execution.

Okay, great. And just with the repo rates, obviously, they picked up across the board with forward LIBOR curve. When do you think potentially -- this year, is there a possibility for this to start trending back down as the market comes to terms with the reality that the Fed's hands are somewhat tied, at least in my opinion? Is that your thinking there or do you expect them to remain stubbornly high or even increase more? Just your thoughts there would be appreciated.

Well, so here's a real-time example. After the Fed move in December, three-month rates for most people went into the high-70%s and lower 80%s. They are now back into the very low 70%s right now, if -- maybe some people are even in the high 60%s. That is not including the FICC, that's just doing regular repo.

We've already seen as much as a 10 basis point adjustment in 90-day repo, as people's perspectives changes. Yes, to your point, if it appears that the Feds are going to sit on their hands for a little while longer, you will probably see those start to come down to and maybe even a two-month repo, which I think right now, we're seeing 64% to 66% kind of area? That seem -- mid to high 60%s, maybe a little higher; depends on the dealer.

Great. Thanks for taking my questions.

(Operator Instructions)

Brock Vandervliet with Nomura Securities International.

Good morning. Thanks for taking my question. In terms of the pace of the buyback, you obviously bought a lot of shares in the fourth quarter and especially toward the end of the quarter, can you square that up with Safe Harbor rules? It looked like the buyback, especially in late December, may have been well above what I would have thought would have been within that rule. Were there any blocked transactions, that kind of thing, that wouldn't have been within the Safe Harbor?

No, I think -- this is Jim Mountain. I think all of our trades were through our regular buyback program in the open market; there were no blocked trades. Now one of the things that happens is that Safe Harbor limit gets adjusted every week based on recent volume, so that does float up and down week to week but all of our trades were open market within the Safe Harbor.

Okay. Are there any constraints imposed by any of your counterparties on leverage levels or buyback activity?

None. I will tell you that you might have under the ISDAs, you have a lot of terms but none of them would have any leverage terms even close to anything that anybody (multiple speakers) has. They -- it would be like stupid numbers.

Okay. And just flushing out some of the comments in the opening remarks, it sounded like you may be taking a hard look at the dividend going forward, bringing that more in line with payouts in the group. I guess, just in general, as you look back at 2015, how do you square up dividend performance versus book value?

Well, the dividend performance, particularly in Q2, Q3 and Q4, was core earnings exceeded the dividends paid, but taxable earnings can be different than core, right? So at the end of the year, when you get your statement of dividends, the taxable and the core won't be the same. If we look at the first quarter of last year, we distributed more than we earned taxable and that was, I would -- account for a lot of what happened last year in that regard.

As I talked to David Walrod with his question a few minutes ago, we've indicated strongly that the $0.33 dividend has thus far, according to our estimates, exceeded the amount that we believe we have earned in taxable in core. That was on purpose and the Board continues to maintain that. We have not announced a March or a future dividend yet.

Got it. Okay, thank you.

Douglas Harter, Credit Suisse.

Just to follow-up on the earnings questions. How do you guys think about the forward-starting swaps when you're thinking about setting the dividend or thinking about the earnings power of the portfolio?

Right. So everything is modeled out and you push a button and it pops out what would happen today, tomorrow, for the next year, right? So as we get -- approach some of the forward-starting swaps, we may go ahead and roll some of those out or we may just cancel some of them. They are booked -- they are marked book to value every single day, so to the extent that the rates rally here, our book value at any given point in time would reflect that.

So the forward amount of our swaps has declined and I expect it to decline a little bit in the future as well. Sometimes, Doug, you have to wait right until you get to that point and analyze it. So we're looking forward right now. We have it all modeled out and we see what we think we're going to do but we, oftentimes, will wait until 48 hours before that thing starts to know exactly what to do.

I will tell you there was an instance earlier in the year, where we actually had a swap on for like a week and then we finally decided, okay, we're going to take this off. So it moves according to the rate and the environment and our perspective at a given point in time. Now explicitly, If every single forward-starting swap came on right now, that would hurt your core earnings considerably. That would not happen.

When you say you're thinking of taking down the forward-starting swaps in the future, would that be to replace them with current pays or is it just reduce the total swap exposure?

A mix of both, actually.

Okay. Thank you --

Because, remember, we have stuff rolling off all the time as well. It may have been an original five-year swap that we put on five years ago and that's going away so you have to look at the whole book, not just, like, one point in time.

Makes sense. Thank you.

There are no further questions at this time. I will turn the call back to you. Please continue with your presentation or closing remarks.

Thank you everyone for joining us. Once again, we get calls from analysts all the time. We are usually around to call you right back and if we are on the road, we will get back to you the next day.

Please reference our monthly company updates, which we put out usually toward the end of the month and you can follow-up with any calls after that comes out. Thank you very much and we look forward to talking to everybody next quarter.

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.