Invesco Mortgage Capital Inc (IVR) 2010 Q2 法說會逐字稿

(audio in progress) information that constitutes forward-looking statements within the meaning of the US securities laws. Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, targets, expectations, anticipations, assumptions, estimates, intentions and future performance.

Forward-looking statements also include statements regarding our ability to repeat performance trends in net income, net interest income, return on equity, portfolio yields, expense ratios, improved stock liquidity, interest rates and their effect on pre-payment risk, our ability to generate future dividends, the strength of our investment and management team, investment opportunities in the mortgage loan area, our managers' activity level in the mortgage loan area, our ability to deploy capital from our follow-on common stock offerings, repurchase agreement, funding costs and terms, our portfolio composition, the constant pre-payment rates of mortgage-backed securities, credit performance of mortgage-backed securities, our ability to reduce risk through our hybrid REIT strategy and our ability to capture opportunities in the mortgage environment.

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Good morning, ladies and gentlemen. Welcome to Invesco Mortgage Capital Inc.'s second-quarter results conference call August 4, 2010. All participants will now be in a listen-only mode until the question-and-answer session. (Operator Instructions). As a reminder, this call is being recorded August 4, 2010. I would now like to turn the conference over to the speakers for today, Richard King, Chief Executive Officer; John Anzalone, Chief Investment Officer; and Don Ramon, Chief Financial Officer. Mr. King, you may now begin.

Good morning, everybody. Welcome to IVR's second-quarter earnings call. In addition today, we have Rob Kuster our Head of Credit.

IVR had strong results in the second quarter earning $0.91 per share. Don Ramon, our CFO, will walk you through some of the details in a few minutes. During the quarter, we raised additional capital and invested it efficiently with very little earnings drag. The difference between the dividend and the earnings per share this quarter is a result of share count timing issues.

Since the equity raise was completed mid-second quarter, the third quarter dividend will reflect the full earnings power of the latest capital raise. The equity raise successfully increased our stock's liquidity and lowered our expense ratio. We took advantage of continued non-agency opportunities and prepaid protected agency collateral pools and actually increased our return on equity.

In addition, at the end of the second quarter 2010, Invesco Mortgage Capital completed its first full year. So this is an appropriate time to reflect on what we achieved relative to two primary goals. The first to provide attractive returns to our investors primarily through dividends. Since our IPO, we paid $3.18, which is a 15.9% yield on our IPO price.

Our second goal, to maintain or improve a relatively stable book value and we have done that as well. We accomplished this while tripling the Company's outstanding shares of common stock via two follow-on equity raises to make IVR more competitive now and in the future in terms of size, expenses and liquidity.

The reason we have performed well comes down to the following and John Anzalone will expand on these in a few minutes. We are very strong in the agency mortgage space. Our asset selection resulted in very slow pre-payments and we have largely avoided buyouts after having benefited in 2009 from owning hybrids. IVR pre-pay rates on agency MBS are lower than market cohorts. In non-agency space, our loan level research generated huge opportunities and we have experienced very strong early cash flow with higher pre-payments and lower severities than modeled boosting our income.

We continue to see great opportunities in this space. It remains, we believe, the best loss-adjusted yield in the fixed income market. Our CMBS portfolio funded through TALF is performing very well and is seeing strong price appreciation. We are also excited about taking advantage of the revival of the new issuance in the CMBS market.

Our credit team and deep resources sets us apart in this space. We have successfully levered the relationships with Invesco Real Estate and Wilbur Ross and recently purchased several distressed resi and commercial mortgage opportunities in the PPIP fund to IVR's benefit. We are also looking to capture similar opportunities in IVR directly in the future.

The hybrid strategy really sets us apart from our competitors. As mortgage rates have rallied, we have steadily migrated our equity allocation further into credit asset classes and away from agency MBS that continues to relentlessly rally. Our diversified financing strategy continues to differentiate the platform as well. And we have successfully maintained high gross ROEs in both credit and noncredit asset classes while maintaining low overall portfolio leverage.

We have maximized the government nonrecourse leverage to its fullest, tapping into PPIP and TALF, which is a true differentiator and benefit to our shareholders. The diversified asset mix, combined with our hedging strategy, provides excellent offsetting risk profiles. The hybrid strategy is playing out as we predicted. Our earnings per share is a reflection of this and we look forward to continued strong earnings. We are excited by what we see in the markets now and our target assets and we certainly welcome market volatility because it does allow our hybrid strategy to create value. With that, let me turn it over to Don Ramon.

Thank you, Rich. During the second quarter, we completed a follow-on common stock offering and this was the key driver to the increase in our net income for the quarter. On page 3 of the presentation, you see that net income was $22 million for an increase of $8.8 million over Q1. The net income translates into earnings per share of $0.91 for the quarter, which is an increase of $0.14 over the previous quarter. One of the questions often asked is how much of that is related to core earnings and as you can see from the graph on this page, the key driver to our earnings for the quarter was net interest income and the increase in net interest income related in that net income gain.

Turning to page 4, you can see the trend over the last four quarters continues to be very positive. Both our average and gross ROE continued to perform well as we expected with our portfolio driving this key change. When you look at -- on the lower left, you can see where our net portfolio yield reduced slightly by about 20 basis points as we expected with an additional capital raise since the yield on non-agencies had come down. We offset this slightly with higher leverage associated with that portfolio. So again, overall returns are where we expected them to be.

The last graph on the page shows the improved efficiency we have gained from the capital raises we completed. As you can see, our expense ratio improved by 41 basis points in the second quarter to 2.2%, which is a direct reflection of our ability to grow the Company without significantly increasing costs. With that, I will turn it over to John Anzalone, our Chief Investment Officer, to get into the discussion about the portfolio.

Thanks, Don and thanks again for everyone for taking the time to dial in. Let me start out with the quick portfolio overview on slide 5. As you can see on the chart on the upper left, the portfolio grew materially after the capital raise. We deployed the money very quickly and thus were able to minimize earnings drag. If you look at the graph on the lower left, you can see how our equity allocation changed after the deployment. We increased our allocation to non-agencies, which is now up to 63% as loss-adjusted yields remain attractive.

We decreased our allocation to agencies as dollar prices increased and valuations richened. Our PPIP allocation almost doubled as that fund continues to add attractive assets. And finally, we did not add any CMBS as the TALF program expired during the first quarter.

On slide 6, this simply gives a breakout of how our equity allocations have evolved over the past year. Again, our allocation to agency mortgages has decreased over time as we anticipated the GSE buyouts earlier this year and then subsequently invested less newly raised capital to the sector as prices rose and valuations increased.

Non-agencies still look very attractive as loss-adjusted yields are currently between 6% and 8% and with the terms and availability of financing continuing to improve, we have increased our exposure in that sector. In CMBS, the relative position shrank as we grew capital and didn't add any new bonds. And finally, as I mentioned, our PPIP allocation continues to grow as that fund adds assets.

On slide 7, the graph on the left shows how the yield on our agency positions has changed. Currently, our agencies are yielding 3.1% with a net interest margin of approximately 170 basis points. This is a reflection of both lower rates, as well as tighter spreads on mortgages.

On the right, you can see the pre-payment history of our pools. This has been a pretty remarkable performance, especially when you consider that we have been concentrated in higher coupons across the board. In fact, our fixed-rate collateral paid at a little more than half the speed of generic collateral during the second quarter. This is due entirely to collateral selection as the vast majority of our portfolio is concentrated in pre-payment impaired pools such as low-balanced collateral and investor properties.

You can see we had a spike in our hybrid ARM pre-pays, but the good news is that we anticipated this and sold out of almost all of our position this year. In fact, hybrids now represent less than 5% of our agency book, down from over 22% at year-end.

On slide 8, let me give you some highlights on our non-agency positions. As you saw earlier, the percentage of equity allocated to non-agencies has steadily increased. There are a number of reasons for this, including attractive loss-adjusted yields, attractive and increasingly available financing and a tremendous technical imbalance where diminishing supply combines with increased demand.

The positive tone in the non-agency market has inevitably led to lower yields, but applying a moderate amount of leverage has allowed our ROE to remain attractive. Our credit positions continue to perform within our expectations and our pre-pay experience has been very positive here also. Except in deep discount non-agencies, we want to see faster speeds. Our portfolio has consistently paid faster than our expectations, which has helped boost returns. And with that, let me hand it back to Rich for some closing comments.

Sure, thanks, John. Let me just make a few closing comments and then we will open it up for Q&A. We are pleased with the business model we employ, which allows us to use our very large platform to seek a relatively small number of the best opportunities in what is a very large US mortgage market. The result of all of this has been an attractive dividend yield.

A quick word about the portfolio we have put together. Our credit team has done a tremendous job finding very solid value among the massive RMBS and CMBS paper and John and his team have selected agency pools extremely well and it shows up in our results.

Let's talk about the future. There is a large amount of real estate that is going to change hands and there is a large amount of mortgage financing that needs to take place and IVR is well-positioned to participate because we have expertise in both commercial and residential and both securities and loans. We believe it is going to take a few more years before we find a new normal in the mortgage market and in this transitional period, it is quite important not to limit ourselves to one strategy or one means of financing. We are quite excited about how we are positioned now and about our capability and flexibility to respond to new opportunities. Thanks. That concludes our prepared comments. Operator, could you please open the lines for questions?

(Operator Instructions). Trevor Cranston, JMP Securities.

Hi, congratulations on the good quarter. I have a couple things. Firstly, I guess one thing that kind of surprised us in the quarter was the size of the negative mark on your swap portfolio. So I was wondering if you could maybe take us through any changes to your notional balance duration and swap rate during the quarter, please.

Yes, I will just make a quick comment on that and then Don can follow up. I mean I think we have been pretty transparent in talking about the fact that we pursued a strategy that really acts to not take a lot of interest rate risk probably relative to the market. So we have had a higher percentage of our book swapped and we believe that that is going to allow us to have really a more stable book value over a longer period of time, but continue to [bring] attractive dividends into the future. So that is the overall strategy.

So frankly -- I mean we are not surprised. We had -- I think we did reduce the percentage of our book that was swapped with the most recent capital raise. I think it went from in the 80%s down to like close to 70% and that is just of our agency book. And then remember that our agency book, we just showed you, is down to about -- in the low 20%s, 21% roughly of our equity.

And Trevor, this is Don. A couple things just on the comments from what Rich made there is, one, when you look at it, we were at 87% of our coverage on our agency book as of the end of first quarter and that reduced to 71% at the end of June. Again, the way we look at it and John can probably comment on this a little bit better too is we are using three and five-year swaps. So clearly when we added a small amount of swaps during this quarter, we certainly were keeping the [mind] eye to the fact that rates on the three and five-year swaps were going down. And again, we are protected on the long-term basis and not necessarily on just the short side.

So really that is the key impact is the swaps that we have. We are probably sitting on an average blended rate of 235 at the end of the quarter and again, you can look where swap rates were at the end of the quarter and see where that impact came from. But John can comment on the duration, but still we are targeting exactly where we thought we would be.

I guess the other point on that is just when you look at our portfolio, our agency portfolio that we are swapped against there, and John talked about the very slow pre-payment rates, it is a big difference there versus having 40 CPR and stuff on what you are swapping versus 14 CPR.

Yes, that's right.

Okay. That's helpful. And one other more general question. I was wondering if you guys could maybe share your views on what you think the possibility of some type of government-sponsored refinancing wave in the agency MBS market is, whether or not you think anything is going to happen on that front and how you think it might impact the market.

Yes, this is John. Yes, we actually have the fortune of having -- Jim Lockhart is part of the Invesco family working with Wilbur Ross. So we actually asked him that question and the thing he mentioned was that the HARP program already allows for 125 LTV refinancing if the GSEs hold the loan and they have seen very, very little activity there. So we think there is some other things going on. I mean there is still very expensive fixed costs to refinance, things like that.

And then the other problem is if a loan has a combined LTV of greater than 80%, it is going to require mortgage insurance and that, of course, increases expenses for the borrower and unless the treasury goes in and either provides MI, then that is going to be very difficult for any sort of program like that to take hold.

And then there is impediments to that also where if the treasury was to try to do that, that would be part of TARP and it appears TARP is capped and can't start any new programs. So we view that as fairly unlikely to happen. So I mean -- so we think the likelihood is low that that happens.

Okay. That's helpful.

And then on top of that just having low loan balance pools is --

Yes, and how we are positioned. I mean if it were to happen, if someone were to magically wave a wand and make it -- make [SKU] refinancing possible or easier to get, I mean we think that the low-balance story and investor property pools both should offer pretty good protection against that if it were to occur.

Okay, thanks, guys and congratulations again.

Bose George, KBW.

Good morning, guys. Nice quarter. I had a first question just on the way -- the PP income from the PPIP fund, I was just wondering how the recognition of that over time is going to work? I mean could that be lumpy or how do we kind of forecast that number going forward?

It is. I mean it can be. Essentially that portfolio is fair-valued and the change in the portfolio from quarter to quarter is going to flow through our income. Don, do you want to comment?

The way that we kind of model it I guess from our standpoint, we look at it -- we are targeting to 20% returns on that portion of the portfolio. There are going to be times, of course, that we are going to get unrealized gains associated with that since we have to recognize it on the equity method. But you are right. It is a little difficult to estimate that because, again, there is not a lot of clarity from your standpoint into what is in that -- what is held by the PPIP fund. But again, we can't add much more clarity to that other than that we are looking at -- our target is about 20% is how we kind of do it.

Okay. And then just in terms of the cash from that versus the realized or unrealized gains, like when does the cash part of it start flowing in? Is there any way to gauge that?

Not exactly because, again, they make distributions to the partners as they deem fit throughout the time. I think the way to look at it, Bose, the way we do it from a dividend perspective is we have sufficient cash flows from the rest of our portfolio to more than offset that. So there is no real worry. Even at the maximum amount, they'd be $100 million, which, in comparison to the rest of our assets and things, I don't think it would really cause us any concern on a dividend because we clearly have more than enough cash coming in from the rest of the portfolio to cover it. I don't know if that was kind of the question (multiple speakers).

Yes, that helps. Thanks. And then just one other -- (multiple speakers) just on the OTTI impairment that you guys took, I am just wondering what the catalyst is for making that division.

Basically what we do, Bose, is, as you know, we have to take a look at our non-agency or our credit-impaired securities or all of our securities to determine whether or not the fair value, if it is below the book value, if that is going to be something that is permanently impaired or if it is just temporarily impaired. And the analysis that we do on that is just like everybody else. We look at the present value of the cash flows of that particular -- or expected cash flows on each bond on a bond-by-bond basis and we determine whether or not we have anything that is other than temporary.

I think for the quarter, we had a couple hundred thousand dollars worth of other than temporary impairment and really for us, it related to one bond and that one bond -- it is actually a good story. We have really received about 91% of what we paid for the bond and so it is just that the accretion was probably a little bit higher since we got the cash back in such a short period of time and that is what it impacted. So again, the rest of our portfolio is looking good and we don't see any issues. But that is how we go about the analysis.

Okay. Great. Thanks a lot and once again nice quarter.

Douglas Harter, Credit Suisse.

Thanks. I was wondering if you could talk about how your non-agency bonds are performing relative to your expectations and whether you have made any adjustments to sort of the accretable versus non-accretable discount.

This is Rob. I wouldn't characterize our non-agency credit positions as performing right in line with how we have underwritten them. I mean historically we have been very conservative in both our base case and our downside cases and giving very little upside to these positions when we are looking at them from a credit perspective.

I think there haven't been any major changes in our underwriting. We are still anticipating both residential and commercial property prices to soften here over the next -- well, intermediate to long term really. So there is no real change in that.

And I would say the one surprise we have had is -- positive surprise has been that volunteer pre-payment speeds have consistently come in faster than our expectations, but we are not -- we haven't changed our models going forward in terms of expecting fast pre-pays and we are still underwriting to fairly slow voluntary pre-payment rates.

And then, Doug, to answer your question on the amortization or accretion of the discount, again, it is right in line on the non-agencies. Quarter-over-quarter, we are still seeing the same amount of amortization or accretion of the discount that we did in the second quarter [as] we did as a percentage in the first quarter. And the same on the amortization of the premium on agencies. Again, still the same on both. Quarter-over-quarter, about the same percentage.

All right. Thanks. And then sort of given where agency prices are, would you guys consider moving more towards non-agency away from agency sort of in the coming quarters?

That is kind of what we did with the new capital raise and we certainly put more percentagewise more capital towards non-agencies. So we still think that that is probably a better trade. So I don't think -- we are not looking at selling all of our agencies right now because I think our pools are -- I mean we like our pools sufficiently and they have been performing very, very well in terms of the collateral stories, but I think, going forward, I mean clearly non-agencies look like they are more attractive. So I think reinvesting cash flows we tend to think about non-agencies first in terms of that because the yield profile is still pretty good.

Thank you.

(Operator Instructions). Jim Young, West Family Investments.

Yes, hi. Can you discuss why you raised your agency leverage from 7.9 times at the end of the first quarter to 11.7 times and where do you see that going over the third and fourth quarters? And then lastly, how are you managing that risk?

Sure. Thanks and good morning, Jim. We are really looking at the portfolio leverage overall and maintaining it, for now at least, in the 3 to 3.5 range. And so when we look at that and look at the financing costs associated with financing our portfolio and agencies and non-agencies, they are a bit fungible. And so from -- at any time period, we may determine that we are going to finance agency and it so happened that, at quarter-end, we had financed more agencies. So we manage that risk constantly looking at income shocks and price shocks, etc. But it just makes more sense to finance through the agency portfolio than the non-agency. So our non-agency leverage is actually slightly lower than we probably ideally would have if we were running a pure non-agency portfolio.

Okay, thank you. And then you could qualitatively and quantitatively expand upon your comment that you view that the non-agency sector has the best loss-adjusted yields in fixed income?

Yes, when we underwrite bonds and we find bonds that we like, typically the yields -- loss-adjusted yields we are seeing are between 6% and 8%, which I don't know of any other areas of fixed income where you are getting those kinds of returns right now. And on top of that, we are seeing financing become more widely available as the market is getting more comfortable providing that. So that is, from our perspective, that is a fairly -- if we can find bonds we like, that is the real limiter to the equation there.

Okay, thank you.

Daniel Furtado, Jefferies.

Good morning, everybody. Thanks for the time. I think most of my questions have been answered, but I want to go and harp back on credit a little bit here in terms of what you are seeing in the non-agency space on a delinquency basis and just kind of in general the trends in credit for the past three to six months. I know they are in line with your expectations, but we are not exactly sure what your expectations are. And I would assume that expectations for each bond are slightly different. So could you talk in more generalities about what you're seeing in that credit side?

Sure. So yes, you are absolutely right. So every bond that we look at, we look at the underlying loans underneath those deals and form opinions about what roll rates are going to be, what liquidations are likely to be, what recoveries are likely to be and voluntary pre-payments. And the biggest single driver there is that loan level research that we get, what is the current combined loan to value on the property.

And so what we have seen is that -- I mean it is bond-by-bond; it is servicer-by-servicer. So in some cases, you see liquidations occurring quicker than you thought and in other cases, liquidations are happening slower than you thought.

On balance, I think, as we said, the early voluntary pre-pays being higher is definitely a credit positive that is unambiguous. We own top of the capital structure bonds and severities are coming in somewhat lower than our expectations on a bond-by-bond basis when you average it all together. So that is positive obviously because we own the tranches that get the recoveries. The subs get written down, which decreases obviously your collateral going forward. But that is part of the analysis.

I think we still see the potential for prices of homes to come under some pressure through the rest of the year because there is a large amount of foreclosure inventory that is still built. We have seen -- if you look at delinquencies -- for all non-agencies, the delinquency buckets are finally beginning to decline and you see it more in subprime where there is a lot of burnout. A lot of those loans have obviously already -- I mean if most of the loans are delinquent, you are going to start having some burnout. But in prime and in Alt-A, you have also seen a flattening out and maybe a slight decline in delinquency buckets. But as we said, I mean from our loan level work, we are not seeing results that are dramatically different other than, as we said, better pre-payments and a little bit better severities.

Perfect. Thanks for the color. I appreciate that and congratulations on the quarter.

Thank you.

Matt Kelly, Morgan Stanley.

Hey, guys. Thanks for taking my question. So I am wondering how -- in the CMBS market right now, when do you think would be a good time to invest and what sort of -- what are you seeing out there with a lot of the deals coming to market right now?

The CMBS portfolio that we own today obviously is very -- the kind of best senior tranches out there that we bought and all of them are financed through TALF. And we have seen strong price appreciation there and we really don't see an opportunity at this time in the kind of legacy CMBS. But we do see opportunities in new issue. We are evaluating, looking at the B pieces on some deals. We haven't made any determinations, but it is competitive. There are a large number of investors looking at this. So really it is going to come down to where the execution is, but we certainly have the capability and the interest in playing a part in that market.

In the new issue CMBS market, I mean really the spreads at which those bonds are coming at the top of the capital structure are just too tight to really -- you would have to lever them so much that it doesn't make any sense for our portfolio. So I think the rating agencies are being -- the way they are looking at those bonds, they are so overcollateralized that the spreads tend to be very, very tight.

I would further say that we certainly have several analysts whose sole job is to look at new issue CMBS and they are certainly doing that at all parts of the capital structure. There is clearly a lot of money chasing those few opportunities that are in the market right now and we have clearly established that that is the case. I think one of the benefits to our strategy is we don't have to rely on that particular opportunity set. I mean if it falls into our hand, and it is a great ROE and a good collateral pool, we will certainly purchase it if it makes sense. Otherwise, we have other opportunities that we can take advantage of also.

Okay, thanks. That is helpful. And just on -- I was just wondering to drill down on the repo market a little bit by different asset classes, what you are seeing across the spectrum there in terms of availability and terms.

Yes, and I will start with the agencies. Agency repo has been pretty steady. I think our average cost is around 30 basis points for one month repo on agency securities. So that has been unchanged and remains widely available and we have 20 odd counterparties that are willing to lend to us.

On the non-agency side, I think we have seen more counterparties sort of appear and want to participate in that market. I think haircuts are still around and I think our average is somewhere in the 30% range and rates are LIBOR plus, call it, on average around 150. So really it has been the availability has increased. I think the terms over the last quarter or two have remained pretty constant and that is all for one month terms.

And when you look at just the market for non-agency RMBS and what has happened, it is becoming I think more clear to people that the supply and demand dynamic that John was talking about exists and that through pre-pays and default liquidations, you have a steadily declining number of bonds out there and with rates at all-time lows, and you saw the numbers that came out last week -- yes, last week I think -- about how much banks have been purchasing, the supply demand is pretty strong and we are pretty confident that those prices probably continue to ratchet tighter and so the lenders see the same thing. We continue to see more dealers trading in the space and when they trade in the space, they tend to get interested in lending against it. So that is kind of the overall backdrop.

Great. Thanks, guys.

Mr. King, there appear to be no further questions on the phone lines. Please continue with your presentation or closing remarks.

Operator, that concludes our call and thanks, everybody.

Ladies and gentlemen, we thank you for participating in today's call and we ask that you please disconnect your lines. Have a great day, everyone.