Orchid Island Capital Inc (ORC) 2022 Q3 法說會逐字稿

Good morning, and welcome to the third quarter 2022 Earnings Conference Call for Orchid Island Capital. This call is being recorded today, October 28, 2022.

At this time, the company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts are forward-looking statements subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, belief with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from these expressed in such forward-looking statements. Important factors that could cause such differences are described in the company's filings with the Securities and Exchange Commission, including the company's most recent annual report on Form 10-K. The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.

Now I would like to turn the conference over to the company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Please go ahead, sir.

Thank you, operator, and good morning, everyone.

Hopefully, you've received the deck that we put on our website last night. As always, I'll be walking through that. And then at the end, we'll have a question-and-answer session.

Just to start on Slide 3, just to kind of give you an overview of the agenda. As always, I will start with the highlights, our financial highlights for the quarter, then I'll talk about market developments, which kind of drove those results. I'll then go through our financial results in detail, and then spend some time talking about the current portfolio, hedges and so forth and what we did during the quarter. And then finally, I am going to provide a financial conditions update, if you will, just to update everybody in terms of all of the aspects of our liquidity and borrowing capacity and so forth, both for the quarter and as we sit here today.

So with that, on to our financial highlights for the quarter. We had a net loss per share of $2.40, net earnings per share of $0.26, excluding realized and unrealized gains and losses on our RMBS derivative instruments, which includes net interest income on interest rate swaps. We had a loss of $2.66 per share from net realized and unrealized losses on the same RMBS assets and derivative instruments, including net interest expense on our interest rate swaps. Our book value per share was $11.42 as of September 30 versus $14.36 at June 30. In Q3, the company declared a subsequently paid $0.545 per share in dividends. And since initial public offering, the company has declared $64.33 in dividends per share, including the dividends declared this past month. Total economic loss of $2.40 or 16.7% for the quarter. On October 30 (sic) [August 30], the company effected a 1 for 5 reverse stock split. All shared per share numbers have been retroactively adjusted to reflect this in all of the slides in the deck today.

Now just to go through the markets that we've been operating in, as you can see on Slide 6. This story has been the case now for some time. If you look at these lines on either the left side or the right side, the red line there is the treasury curve or the forward or swap curve as of June 30, the green line is the same curve as of 9/30 and then the blue line is the one as of last Friday. And the development that you just continue to see is the front end of the curve keeps rising as the market continues to price in not only higher fed increases, but bringing those increases forward. The market expects the fed to raise rates 75 basis points next week and either 50 or 75 again in December and likely a few more hikes, although probably smaller in size in 2023. And so that trend just continues as we move through time this year as the fed, especially in Q3, and we'll talk about this more in a minute, has become extremely aggressive and hawkish in their desire to not only raise rates into restrictive territory, but to do so as soon as possible.

If you look at Slide 7, and I don't need to spend a lot of time on a lot of these slides, you are all familiar with the story, but this is just a convenient picture. As you can see, with respect to the 10-year or the 10-year SOFR swap really starting right at the end of July, a meaningful shift. The 10-year was at 260, 10-year SOFR swap is inside of 240. And it got is over 4%. It's -- since the data point -- last data point here has come off a little bit, but both of these numbers got well over 4%. So a very meaningful shift in a short period of time. And if you look over a much longer period on the right, you can see the same thing. These all reflect the steps that the fed talk really starting about mid-August when they pushed back very hard against the notion that was being priced in the market at the time that the fed was going to continue inflation and by sometime in early 2023 start to ease. And they've made it abundantly clear that's not the case that they're going to do everything they can to contain inflation and raise rates as much as needed as soon as possible.

If you look at Page 8, you can see not just -- I'm sorry, I got ahead of myself. That's right. Page 8, you can see the effect on the mortgage market. There's 2 slides here on the top, you see the most recent data just going back 1 year. But on the bottom, we try to give you some historical perspective. And you can see the spread of the current coupon to the 10-year treasury. There are many measures to use, to look at, to get a sense of the relative value of mortgages. This is just one, but it is representative. And as you can see, especially on the bottom chart, the spread of the current coupon mortgage to the 10-year treasury, really starting in 2013 through the onset of the pandemic, was very stable, trading in the high 80s for the most part. In March of 2020, that number spiked out quite a bit. But really, this year, it's gone much higher. We peaked at about 190 recently. And as we sit here today, as of last Friday was 183 basis points. So obviously, mortgages have done very poorly. But really, it's just all risk assets, and we'll say something about that in a moment. But obviously, it's been a very tough period for mortgages, particularly in the third quarter.

Slide 9 just gives you another perspective on the market. The takeaway here is that the curve is obviously very inverted. If you look at the bottom right, you're just looking at the spread between the 5- and the 30-year treasuries. And you can see we're fairly negative here. And also, it's interesting to note that's occurring at the same time that both the yield on the 5-year and the 30-year are at basically the highest level they've been in 10 years. So obviously, they're not normal times versus what we've been accustomed to of late.

A couple of slides -- one last slide here, just really something to keep in mind of on Slide 19. These are just holdings by the fed and by commercial banks. This is something to keep an eye on over time as we enter quantitative tightening and reserves are drained from the system. Both of these lines will draw down. The question is how far and if what rate, really not much to say other than just to keep an eye on that.

Now turning more specifically to the mortgage market on Slide 11. The top left, I think, is very telling. If you look at this, what we're showing here are the price of 4 representative coupons in the fixed income or in the mortgage universe, Fannie, 30-year 3s, 4s, 5s and 6s. And what you can see is these are normalized, so taking the price of the giving coupon as of 6/30, setting that to 100 and then looking at how it performed over the course, not just of the quarter but into October. And it's interesting, when you look back to late July and early August, that's when the market thought the fed was going to pivot in early 2023, and mortgages were doing very, very well and especially lower coupon, longer duration mortgages and they outperformed meaningfully. In fact, higher coupons were doing fairly poorly simply because they're going to be subject to faster prepays and their convexity with we were talking hit.

As the fed pivoted and all of a sudden rates start going the other way, then everything flip flops. And you see that 6s did very, very well. Their short duration makes sense. And the lower coupon hit poorly and there's also the spectrum of banks selling or Bank of Japan selling. And so that performance turned around very meaningfully. But this is a very useful chart because at some point, I do -- when the fed ultimately does pivot, I think what you see on the left side of this page is what you're likely to see. And so it's a very -- kind of a microcosm of how the mortgage market is going to perform over the course of the next year or so. Basically, when rates are continuing to rise, what you see on the right side is likely to prevail. And to the extent the fed pivots and we rally, what you see on the left side is what you're likely to see happen.

The rest of the slides on bottom left, I'll just go through these quickly. These are the roles, I would like to give you data on the current production coupons, like 5s and 5.5s, 6s and 6.5. But we just don't have enough data. They're just new because rates have sold off so fast. And even though these coupons are now the "current coupon," they haven't been sober long enough that we have any data. In fact, if you look at the top right, when we see pay-ups for certain specified pools, we have added 5s and 6s, but we only have a very little amount of data. So as we move through time, that will come in. In the meantime, just to note with most of the market trading at a discount, the need for call protection that are offered by specified pulls really just isn't there. And as you would expect, those pay-ups are very subdued.

Now another story on Slide 12. This is very important. This is basically our proxy for volatility in the market. And as you can see, for instance, on the left side, back in March of 2020, volatility spiked up very, very high. But in fact, if you look at what's happened in the current year, it's even higher. And more importantly, if you look really what happened starting early in the year, when vol started to increase, it's just been a steady rise, and it's risen pretty much all year, and it really hasn't abated that much. And that really is just -- makes for a very challenging market for mortgages as the most rudimentary sense when you own a mortgage, you are short of prepayment option or short volatility. So obviously, if you're short in volatility and it's rising throughout the year, that's not a good thing. And as solely an agency mortgage investor, we're just subject to that pain and there's really nothing we can do.

Going through the next few slides on the market, Slide 13, limited information here. These are just OAS numbers on a bunch of coupons, unfortunately, again, the more recent production coupons, 5s and higher, there just isn't any data. So we really can't show much there. And the other one is just pay-ups, which, of course, are extremely depressed on the right side.

On Slide 14, this just gives you an overview of basically how all the asset classes have performed. And I think the most important takeaway here is that historically, high-risk sectors of the market like equities tend to be inversely correlated with extremely low risk sectors of the markets like treasuries. And of course, that has not been the case this year. As you can see, whether you look at Q3 alone or the year-to-date numbers, all the high-risk sectors of the market, especially equities have negative returns, but so do treasuries. And so all risk assets in this environment are suffering meaningfully.

Just on Slide 15, this is new. Basically, this captures all basically the entirety of the domestic fixed income universe. So everything from investment-grade corporates down to BB rated CLOs and CRT bonds and everything in between. Just point your attention, one of the first columns on the left as current. So that's the current spread, and this is as of 9/30. If you look over to the right, this one that shows the 2022 highs and then where we are at 9/30 versus that and a 0 basically tells you that we are at the high spread. And as you can see, pretty much the entire universe is either at or very close to the widest spreads that we've seen over the course of the year and, in fact, many years. So obviously, all 6s or the fixed income market are suffering in this type of environment.

Finally, a few more -- one more page on the market before I talk about our results. If you look on the top left, as you can see, the red line there is the mortgage rate. It, in fact, did past 7% this week and the refi index every week that it comes out of late, it makes a fresh multi-decade low. And if you look at the bottom, you can see the percent of the universe that's refinanceable which is the shaded area is effectively 0 and the refi index, as I said, just keeps dropping. The primary sector, secondary spread has just been choppy that reflects the volatility in the market generally. And really what originators are dealing with now is what to do with headcount and capacity because, obviously, this market is very, very bad for the housing market as a whole.

Now we can talk about our financial results. I want to spend a fair amount of time on Slide 18. We have this slide every quarter. And if you look on the left-hand side, this is a very simple disaggregation of our income statement. So on the first column, basically, you see all of our components of interest income and expense and then the expenses we incur for the quarter. And then the middle column are all of our realized and unrealized gains and losses. So just to talk about the middle column for the moment. As you can see, we had a book value decline, and it's all reflected in the fact that the realized and unrealized gains or losses on the mortgage portfolio far exceeded the gains on our hedges, and that's what led to the book value decline. So obviously, that's the effect of artifact that what we just discussed.

Now if you look at the first column, I want to point out a couple of things. So first, we show our interest income. That is -- we use the fair value option of accounting. So basically, what we do is we take the coupon times the par, and that's the dollar amount. The interest expense is what we pay on our repo. We do use hedge accounting for tax purposes, but not for GAAP. So we don't reflect that in this number. And then, of course, we have our expenses, and then we have a net interest income of a little over $9 million, which is $0.26. Now that's $0.26. We paid a dividend of $0.545, so I need to point out 2 things. One, as I said, we don't use hedge accounting, but we do hedge. We have a number of hedges. We'll talk about that more in a moment, but those hedges are very much in the money. We're paying fixed or receiving floating in the case of swaps on our futures and our swaptions. And so as those hedges have become very much in the money, net to us, we are receiving cash flows and the cash flows attributable to the third quarter of 2022 was about $5.043 million to us. That's $0.143, which again, is not reflected in this table because we don't use hedge accounting.

Also, our portfolio, which we have paydowns on, has a weighted average price under 90, so significant discount. And so as we do get paid down, we get paid back at par, we have discount accretion. And even though prepayments are low, the magnitude of the discount is extremely high. So the accretion of discount for the quarter was $4,647 million, which is $0.132. So for the quarter, the benefit of our hedges, if you look at this, say, in an economic sense, not just a GAAP reporting sense, the effect of the hedges was another $0.143. The discount accretion was about $0.132, the 2 total $0.275, which when you add that to the $0.26 we reflect here gets you to $0.535. So our economic income for the quarter was $0.01 less than the dividend.

So I just want to bring that to everybody's attention because this is where the shortcomings with our GAAP accounting can lead to some confusing outcomes. And it's always been the case that we presented this way. It's just has not been the case that the magnitude of these differences were anywhere close to this high premium amortization when the portfolio was at a premium or hedges when they were out of the money, these were much smaller numbers. But today, they are very large. And in fact, more than doubles the net interest income number. So the economic net interest income was very much in line with the dividend. With respect to the right-hand side, just more of the same, you can see the first column is the return of the pass-through portfolio, obviously, very negative with the widening that we've seen in the sector.

Moving on somewhat quicker and some of these subsequent slides on Page 19. This is just a proxy for our net interest income over time. I think one thing that's interesting takeaway is even though the red line, our economic interest or cost of funding has increased, our net interest margin is 210. And by the way, that's not reflective of everything we just discussed in terms of hedge accounting and discount amortization. So it's actually understated, if you will. It's more like 260. But even at 210, it's really more or less in line with where we've been. In fact, the low was back in late 2019 when it was about 155 basis points. So the net interest margin in this environment is not poor even with funding costs so high. And we'll talk about this more in a moment. It's actually a very attractive environment to invest in, but it's also extremely volatile one and one where rates and volatility are working against us. So you have to weigh those factors in everything you do.

Going on forward, Slide 20 and just a more historical information. I do want to talk about Slide 21. This is, of course, about our importance, our leverage. Obviously, in this type of environment, we have to be very active in managing our leverage. Of course, if you have a book value decline, that means your equity is lower, so you have to lower your liabilities to keep your leverage ratio in line. You don't want it to get excessively high. That means you have to sell assets or short mortgages in one other form or another. As you can see, the leverage ratio was 8.2% at the end of the quarter. As we sit here today, it's our economic leverage ratio, which would be liabilities divided by our equity adjusted for any longer short TBA positions we might have, that number is actually 7.3% as of Wednesday's close of business. So 7.3% today, 8.2% at the end of the quarter. On the right-hand chart just shows us for our peers that because we don't have all the information on our peers for Q3, this is still data as of Q2, so I really don't need to say much about that.

Turning now to Slide 22. One thing of note here, we've talked late last year, earlier this year about increasing our exposure to IOs because we thought that pass-throughs would widen and rates would increase. That work -- the IO portion of that worked out well. The IOs did very well, so much so that they're at a point where they really can't do any better speeds have slowed so much. We basically extracted all of the value out of those assets, and they're no longer effective from a hedging perspective. And so, as you can see on the left-hand side of Slide 22, what we took -- or the right, we took that position from about $175 million down to $50 million. And actually, subsequent to quarter end, we've strengthened even more. We sold another $28-odd million market value of IOs. So we only have about $22 million IOs left. They're just not much use to us anymore. And so the capital weighting has been shifting more towards pass-throughs. When we dealt with the rate volatility and so forth more on the rate hedges versus just using IOs.

Now turning to Slide 24, just to update you on the portfolio. As I said, we had to deal with decreasing equity and increasing leverage. So we had to reduce the portfolio. What did we do? I mentioned that we sold IOs, that was one way. With respect to the pass-throughs, you can see our largest holding there is in the 3% coupon, about $2.3 billion. That's actually about $1 billion less than where it was at the end of the second quarter, but we didn't just sell those. We actually added to the higher coupons 4.5s and 5s, which at the time, we're a lot closer to par than they are today. But -- so net of that's about 4. So we reduced our exposure to 3s by $1 billion, added to the higher coupons by 4. The net of that is a net decline of $600 million, which is what we, in fact, had for the quarter. And then on the bottom of the page, we have our hedges.

I just want to point out before we move on 2 points. If you look at the market value of the mortgage assets about $3.2 billion, the notional on the hedges is now higher. It's a 107% of that balance at $3.425 billion at the end of the second quarter, the equivalent number was 93%. So we've upped our hedge exposure, as I mentioned, reducing the IO exposure and picking up the hedges in other products, and that's how we've done that. And then just one final point. This is a model based on the right-hand side, you show our exposure to interest rate shocks and it's very balanced, which is obviously something desirable for us to maintain.

The next slide, we go through speeds. Obviously, this is not a good story since everything is at a discount. Slide 26. This is, again, kind of very intuitive. As you look at interest rates here on the right-hand side the tenure, that's actually stale, as I mentioned, the 10 year is north of 4 and paid out and again, what we're doing here is we're normalizing our paydowns because the size of the portfolio changes over time. So we just take the dollar amount of paydowns and divide it by the principal balance of the portfolio. And as you would expect, with rates high, it's lower. Those dotted lines represent one standard deviation above and below average going back to our inception, March of '13, and we're approximately 1 standard deviation below average. Back in '13, we actually got fairly far below that. We're benefiting from the fact that most of the passages that we do own, while they are discounts are seasoned. So they do pay a little faster, and that's why this number hasn't decreased more than it has.

Slide 27 is a snapshot of our funding. You can see all of our counterparties on the left. If you look on the right, there are several lines. There's a red line, it's actually a light gray line, which you can barely see. That just basically represents average 1-month silver, which is the benchmark that is used for our funding. And then, of course, our cost of funds. And as you can see at quarter end, it was round-around 250. Our hedges are in the money. So that gap between the red line and the blue line has been growing. Obviously, these numbers are as of 9/30 in all likelihood by the time we get into early 2023. These numbers are all going to be north of 4 simply because the fed has a lot more hiking to do.

One last slide before we conclude the discussion of the portfolio, just our hedges on Slide 28. As you can see on the top left, as we shrank the portfolio, our futures positions have been reduced slightly. We show $750 million, approximately short of 5-year contract, that was down from about $1.2 billion. And the ultras we were down, we were about 2.75. So we reduced that. We have added to TBAs. We're at $475 million. That's versus $175 million at the end of the previous quarter. I do want to point out on the top right, I talked about our hedges. This is where it becomes very explicit. If you look at our swap position, the average fixed pay rate, 1.39% today, 1.39% at the end of last quarter, but the receive rate, as you can see, has moved materially in our favor, which means the net estimated fair value has gone up. So that will continue to be the case as the fed continues to raise rates. With respect to the bottom right, these are our swaptions. I just want to point out one thing. If you look at the fixed pay rate, you see it rate went up. That's just because we're basically delta hedging with these positions. So as the market moved and has moved a lot, that we've just continued to adjust these hedges so that they're kind of in an optimal position in terms of the rates on these instruments. And so that's pretty much it for the portfolio.

And what I said I wanted to do is spend some time basically just going over kind of a very current update on our financial condition. So first of all, in terms of liquidity, obviously, very important to us. As of 9/30, our cash and unencumbered assets represented 53.5% of our equity. Very healthy cash balances. We maintain that number between 40% and 60% basically since our inception, and we've done so since the end of the quarter. So we have very ample liquidity. We don't have any problem meeting margin calls or the like. In fact, with respect to repo, we have very ample access to repo. We have borrowing capacity in excess of our needs. Our hair cuts have been stable with one exception. There was one counterparty that did raise their haircut by 1%. We were told it was more of an algorithmic thing basically just capturing the fact that volatility in the market was higher their models, their risk models told them they had to raise haircut slightly, they did so by 1%.

We've had other counterparties just to be fair, who have talked about raising haircuts over the last month or 2, but really haven't seen it just that one party. And by the way, our portfolio remains 100% agency MBS pools, don't even have much IOs left. So with respect to the ability to fund these are instruments that are quite easy to fund. And I talked about our leverage ratio. Obviously, we've been maintaining that in a level that we're comfortable with, and that has really driven a lot of our portfolio decision-making to the high level.

And I just want to point out that our TBA position, what I mentioned was $475 million at the end of the quarter, we're actually short. We sold forward $675 million now. And that is very, very useful for us because that allows us -- remember, we sold these forward so that, one, it's a very effective hedge against basis widening, but also, it allows us a lot of flexibility in terms of maintaining our leverage ratio. So to the extent that rates move against us and we want to lower our leverage ratio because it's moved against us, we can fill as many by selling assets into this TBA short as much as we need to do so and where we could sell none if conditions warrant. So it's been very effective in terms of allowing us to one hedge, but also have tremendous flexibility in maintaining our leverage ratio. And it's just a very effective way of dealing with the issues, and I mentioned the IOs and so forth before, not so useful.

A few more points with respect to funding. Most of our funding is done at a spread to SOFR. It has been trending higher, which basically reflects 2 things. One, you just have financial conditions tightening generally. And then two, I think there's a lot more uncertainty in the marketplace over the path of rate hikes and that's just reflected in a wider spread. So we have seen some widening in the spread to SOFR over the course of the year. We actually did put in some basically floating rate funding earlier in the year, whereby we paid a spread over SOFR that was fixed at initiation. That was actually at a very tight level. So that's been nice.

Now I'll just a final point just talking about our view on the markets. Obviously, we view the market as attractive in terms of assets, in terms of returns that are available and so forth. But as we learned in Q3, when the same situation was the case, we had a lot of volatility show up in August, late August, September and in October. And so caution is definitely warranted that, and we do have to maintain a leverage ratio at a safe level. So while the market is extremely attractive, we do have to be somewhat cautious. We do have an ATM. We have the ability to raise capital when we think it's prudent to do so. And we may do so if that's the case.

But that being said, if the sector gets weak again as it's done in the past, we can buy back shares. And over the course of the most recent 90-plus days, we, in fact, did not sell any shares on our ATM and instead bought back a little over 5% of our outstanding shares at a substantial discount to book value. So far, we have opted to just buy back shares and capture that discount as opposed to try to issue shares because we really -- it's hard to have a lot of conviction in thinking that this period of rising rates and high volatility is over. At the end of the day, it seems that inflation is driving that. And the fed is very keen on containing inflation, and the data just keeps being strong. So if this data keeps being strong and the fed has to react to it, we're going to continue to see more of the same. Eventually, I would assume that's going to end, but we don't know with any conviction when that will occur. So we will continue to operate as we have.

So that's pretty much it. And with that, I will turn the call over to questions.

(Operator Instructions) Your first question comes from the line of Jason Stewart with JonesTrading.

I wanted to ask you about your thoughts on the forward curve and whether you think there's going to be effect to it and how you position the portfolio for that?

Sure. I really don't put a lot of -- and I'll let Hunter speak to this, too. I don't put a lot of stake in it. As you know, last Friday, that's when this whole pivot thing came back into the market. There was a couple of things. It was a tumorous article saying that the fed might consider winding down their hikes or decelerating daily, the fed governor of San Francisco said the same thing and then the Bank of Canada didn't quite hike as much as they thought the market thought they would ECB was somewhat dovish yesterday. By the way, apparently Tim Ross had a tweet today saying the market the fed might reconsider what they do in December and do 75.

At the end of the day, the data is going to drive it. And I don't care what the forward curve says or what Tim Ross says or anybody says, if next -- whatever it is in 2 weeks from today, when we get the next CPI number, if it's meaningfully higher than consensus estimates, they can't pivot. So -- and from what I've been reading, there's a lot of evidence that inflation is fairly well in green. So if you wanted to make the argument that inflation could stay high for a while, it's easy to do. I'm not an economist, so I can't really do so with any great conviction. But I do know that until inflation really slows, I don't see how the fed can do anything other than continue to try to get ahead of it.

Yes. I think that's exactly right. And from a portfolio perspective and a hedging perspective, we have a limited number of tools given that amount of uncertainty. So the things that we can do is that we've noticed, of course, to the extent that inflation comes in hotter, mortgages obviously have -- are going to respond negatively to that versus other risk assets. So we continue to increase our hedge allocation towards mortgage basis sensitive hedges like TBAs. And then the other thing that we've been looking at and have not done much on this front, but is being long -- long net long volatility. So to the extent that there's upside surprises, we benefit from an updraft in volatility. And then we have been looking on the front end of the curve to do some things in conditional space, just so that if higher for longer plays out and proves to be a sort of a mantra that we can benefit from that without being locked into it in a more symmetric fashion. So that -- in other words, if we're wrong, we lose some premium on some options. But if we're right, then we can benefit from the fact that we're going to see higher funding costs for maybe another year or 2 or how a long this plays out.

Yes. Okay. That's helpful color. And how does the TBA short fit into that thought process?

The basis, that's -- as I tried to stress in the slide deck, I mean the mortgage basis has been widening. We have a lot of disclosure to 3s. That used to be the desirable place to be earlier in the year because nobody wanted to own production coupons because of potential speed increases, nor did they want to know on the deep discount so that what they referred to as belly coupons were fairly desirable. That's changed of late, they've become less so of it no better way to hedge than shorting the underlying, in this case, the 33. So that's about as effective as a hedge as you can use just because it obviously trades with your portfolio.

Yes. I think 33 roles in particular, are very, very low. So there's not a high explicit cost of doing so. They're not trading special at least. And for us, it can be costly hedge in this manner, but also, we like the flexibility of being able to lay off our pools. Most of the specified pool universe at this point has relatively low pay-ups. So we're able to mitigate our risk with respect to mortgage basis by shoring those 2 years.

Yes. I understand the down a coupon strategy. I guess I was trying to just -- last question and then I'll jump out of the queue. I understand what your thought on the basis was over the next, call it, 3, 6 months?

Well, it's -- say like I tried to say in the second quarter, I can't see it getting much wider until it did. It still could widen. I mean, it's -- we've got to be close to the end. It's just gotten bludgeoned to death. What would it take to get them materially wider if the fed started more certainly implying that we're going to absolutely sell mortgages or the Bank of Japan, how to intervene and sell mortgages. On that front, the Bank of Japan has intervened in the currency markets and did not sell mortgages. So that's good to see. I just think it's -- it could get a little wider. It's just what's going to get them tighter, and it's really not until that pivot occurs.

When that pivot becomes clear, they're going to snap tighter meaningfully so. So going back to that little slide in the deck where you see how mortgages did in late July and early August, you're going to get a lot of that. So it's hard to guess when that point is and whether it's 3 months or 5 months. But once we pivot, mortgages are going to do well because what's likely to happen is the fed's going to have to tighten a lot, get the economy, get rates in the restrictive territory, and then we're going to have a recession. And when we have a recession, mortgages will do very well. We have no risk component of our asset class. Rates are going to be -- the curve will be inverted. Mark will be expecting longer term rates to rally and mortgages can get back a lot of this widening. So when that happens, I'm very happy to be positioned the way we are.

Yes. I wholeheartedly agree with that. And you can look back to the cross asset, spread metrics that we put in the deck, agency mortgages, in particular, or particularly wide, some other things that are very well insulated from credit risk like the agency MBS are also very wide. Our AAA CLOs are extraordinarily wide. From the standpoint of agency MBS, we're approaching levels that we haven't seen since the financial crisis, really. And somebody -- I think Morgan Stanley was talking about this the other day that what's unique about this environment versus the global financial crisis was there was some a little bit of uncertainty as to whether or not agency MBS were actually going to be credit -- not have credit risk back then because there was a lot of uncertainty around the GSEs.

We've certainly seen that firm up and there's no indication that the GSEs aren't going to stand behind their -- or have the ability to stay behind their guarantee obligations at this point, and they're just really wide. So I think we're going to trade directionally, like we just said, with inflation and the economic data and to the extent that rates go higher and inflation is harder than expected, I would expect the basis to remain weak. And to the extent that things start the fed really starts feeling more comfortable in this concept of pivoting and in that situation, I think that the basis could tighten firmly. But there's a lot of liquidity issues still working their way through the market and not a lot of the traditional buyers, of agency MBS in particular, are just not there yet. And of course, the fed has made their exit this year. So I think the market is still kind of digesting all of that.

We haven't talked about that, but liquidity is not an -- nonissue. There's definitely liquidity issues even in the treasury market, and that gets to this whole idea about QT and how much the fed can drain liquidity from the system. As of now, I don't think it's acute, but I wouldn't be surprised, one of the stories of 2023 is likely going to be when and/or if the fed has to stop QT because liquidity conditions are getting too tight. I mean there's still, whatever, $2.1 trillion in the RRP, so it's not an issue now. But it could become one if they continue to tighten financial conditions. And the other thing is that you're starting to see a little bit of it in the earnings for Q3, but you're likely to see more of it going forward.

But you're going to see earnings are going to be weak and then you're going to see margin pressure and then eventually you're going to see layoffs and jobs are going to go from positive to negative. And that just brings more and more pressure on the fed when conditions are tight, the economy is contracting and people are losing their jobs, that's how it's going to play out. And eventually, they're going to either contain inflation or they're not going to contain inflation, but they're going to be potentially buckle to the pressure to ease because everything else is so nasty. And who knows how that plays out if they don't have inflation under control. But anyway, next year it's going to be equally interesting.

Your next question is from the line of Mikhail Goberman with JMP Securities.

I wonder if you could provide perhaps a book value update for the month of October up to now. And also just kind of a question on capital management going forward, how you guys are thinking about the dividend? And with the stock run up, the really strong stock run up to these past 2 weeks, I guess. How you guys are thinking about those share buybacks with the stack trading, I guess, above book value at this point?

Actually, our book -- we put in the press release that was out there, we saw between $10.50 and $10.60 or $0.60 and $0.70, between $10.60 and $10.70 as of Wednesday's close. So we benefited from the activity in the last few days. I know, for instance, agency reported on Monday and Friday was kind of a rough day, but the mortgage market has done very well these last few days. So we're at the $10.60 to $10.70 range. So I don't know where the stock is trading at this burning moment, but when I came in here, it was below that. And when it's below that, we will consider buying back shares, although I don't know that the discounts quite that large. When we were buying back shares earlier this month, it was 20-plus-percent discount. And if we get back there, we will do so again. So that's book value. That's our approach to the buyback.

As far as our capital really, if the stock trades well, and there's a benefit of raising liquidity, if nothing else in raising capital, but it's really -- I think warrants caution, like I said, in this market. It's just hard to say when that pivot point is. And I know the market wants to do so very badly everybody wants to. But at the end of the day, the inflation data is driving the fed and the fed is driving the market. And I haven't seen much that's convinced me that we're about to see inflation roll over. It's more of the opposite. You keep seeing more and more evidence of it becoming more ingrained even today in the ECI numbers. The public sector employee wage gains, which typically lag prior, we get this right. Public sector wage gains lag private sector wage gains, but they tend to be more sticky once they go up. And they were higher, like more than double the highest quarterly increase in 2 decades. That's not a good sign for the fed. And the fed will pay attention to that. So that's probably why Tim Ross had his little tweet out today about the fed's reconsidering December. That's what's driving everything. And I'd love to raise capital because assets are cheap, but if we're going to get slammed again, I don't know how get an idea that is.

Also, just one more for me. How are you guys thinking about operating expenses going forward?

Well, obviously, they're coming under pressure because as we've shrunk and we've had elevated hedging costs. Although in our income statement, you'll see in our Q, the one line item for operating costs, which is inflated is kind of a quirk in our accounting system where a lot of the costs associated with putting our hedges on are expensed in the quarter incurred versus spread over the life of the hedge. You might have to revisit that with the auditors. I think that's a little penal and it's causing our expenses to look worse than they are.

The other main line item, obviously, is the management fee as our capital has decreased, it's coming down, but it does so with a lag. So it does stick out for sure. And hopefully, at some point here in the near future, our capital stabilizes and maybe even goes up and it will come into line. But for now, it does seem to stick out a little bit. Otherwise, we've had some inflation in our costs. I know our audit fee did go up, just same reason everybody else is raising fees. But -- and the shrinking of the portfolio goes -- makes that challenging, but we just do everything we can to contain costs as much as we can this.

With respect to the operating costs, the fee schedule that we have, just for a little bit of background, I guess, in terms of back up, both the futures hedges as well as the cleared swaps are flow-through and FCM and we have 2 of those. So those schedules on our -- or per contract costs on our cost for cleared swaps, those are unchanged. It's just the activities kicked up. So you can see for the 9 months ended September 30, we are up over double on that particular line item, and that's attributable to that. And our operating costs with respect to management fee and overhead allocation will trend lower as the portfolio turns over. We do have some -- it's a little bit sticky there in the way that the management contract works, but it should be trending down a little bit over time as well, so.

And if need be, the dividend just is reduced, which we've done. I mean, for now, as I went through, hopefully, great detail, great enough details earning right at that number. But Hopefully, we stabilized here. I think we've done enough to do so, but we'll see how it goes going forward.

All right. I appreciate. And then best of luck going forward in this tough environment and best wishes in the holiday season.

Thank you. You too as well, Mikhail.

Your next question is from the line of Christopher Nolan with Ladenburg Thalmann.

Bob, the discount accretion income, is that going to be a recurring deal, do you think? Or what's sort of run rate can we get there?

It looks like it is, for the time being, since 99.99% of the markets a discount, yes, it's a big number. As I said, speeds aren't that fast, but the magnitude of the discount, our weighted average current prices at the end of the quarter is an 89 handle. So it's well over 10 points of discount. So there's a lot of discount accretion. Back in the day, everything was always at a premium, and we always had a lot of specified pulls. So even though we had a lot of premium, we had slow speeds. Well, now we've got even more discounts. And so that number is quite large. Like I said, it was about $4.6 million, which is in pennies, $0.13, I think, it was $0.007, I don't remember the exact number off the top of my head. $0.132. So it's big, especially in light of the fact that our dividend now is smaller than it used to be. So it's a meaningful number.

Chris, that number is on Slide 22. By the way, I'm sure you've seen it, but just anybody who didn't catch that. It's on the right-hand side of Page 22 in the presentation materials we put out, it actually says premium loss due to pay downs, but that's a positive number, so it's discount accretion.

Okay. Good. Thanks, Hunter. And the income from the hedge, I mean, that's just -- I don't think you've detailed it in the past, but is that sort of just an ongoing deal?

Well, it's just so important now. I mean for -- especially the last 2 years, and frankly, up until 2018 and '19, when rates were so low, the hedge cost was kind of a nonmaterial number. I mean the curve was fairly steep, and we as a stable number, the dividend, of course, was higher then. So the impact was much smaller. But now the dividend is smaller and with rates this high and going higher, those hedges are very, very far in the money. They're more in the money than they ever were out of the money, if that makes sense.

Actually, if you look at on Slide 19 has the economic cost of funds, you can see that it got a little high towards the end of the last decade, but prior to that has been very, very low. Now it's going back up. It's not nearly as fast as SOFR is. SOFR is going to be north of 4% very soon. And our hedges -- the swaps were paid fixed rate like 139 bps. This is a meaningful number and when the dividend is smaller, so the combination of the 2 makes the impact very significant.

Great. And just to confirm, you guys have not received any margin calls in the third quarter or the fourth quarter to date. Is that correct?

No. We get margin calls every day. We haven't missed, we get margin calls every day. I mean there's -- we have margining activity on both the hedges and the assets every day. That's -- yes, with volatility in the market, you're going to get margin calls.

That's a daily part of life for us. We are constantly squaring up with the counterparties that we lived -- that we borrow from and for -- versus the value of our collateral and how much money they've given us. But we've not ever failed to -- we've never failed to meet a margin goal in our entire operating history. And we're not in breach of anything right now, so.

There is a follow-up question from the line of Jason Stewart with JonesTrading.

Just wanted to go back to the concept of discount and your view of housing turnover and what the natural rate there is, given where mortgage rates are? And when we look at discount accretion, that becomes a big factor in that equation, but I wanted to hear your view.

Yes. I mean it seems like it's going to continue to slow. Of course, right now is a seasonal slowdown. So for the next 3 or 4 months, it's going to be slow. The question is, how does it come out of the seasonal slowdown. And of course, that's going to be a function of where we are in terms of the market and rates. Certainly, if rates stay at 7%, it's going to be low. The other thing that's going to affect turnover is going to be job growth or loss. And I think the chances that the net change in jobs is going to be south of where it is today is high.

In other words, I think it doesn't bode well for housing turnover in next year. Now that being said, we own a lot of seasoned discounts. They pay at mid- to high-single digits. And so there is still some discount amortization. But I think what's really driving it are 2 things. One, it's the magnitude of the discount. So even though speeds are slow, you're picking up a fair amount of discount amortization. And two, the dividend is just a lot lower than it used to be. So it's more relevant when the dividend was not $0.16, but I think if you look at a one chart at one point was as high as $0.70, that $5 million of discount accretion is a much bigger percentage. And so it means more for us now as to the hedges. But as we come out of this at some point and the curve re-steepens and hopefully, the dividend can recover, and those 2 factors will go back to being not as significant.

We have a lot of collateral that's coming up the curve, too, just in terms of wall ramp. I don't know how long that will continue to -- how long those borrowers will continue to be active in either some type of home equity takeout or just turnover in general. We certainly are expecting to see, I think, the speeds in the mid-single digits, some vintages maybe a little bit higher. We've seen kind of a resilient amount of turnover activity in some of the 2-, 3-, 4-year-old loans. I suspect some of that will taper off with time just because mortgage rates are so high now. But again, a lot of our portfolio is in very low pay-ups to any 3s. We can, at any point in time, dump a lot of that into a TBA bid or grab a few ticks of pay up. We don't have really a lot of exposure for underperformance of that coupon as it relates to specified pools versus the TBA. So we can always reload and go back into something that's a little yieldier to the extent that those -- that discount accretion starts to slow down.

Also to your point, I mean it's -- we could retest the lows of turnover. It used to be not that long ago when turnover was running even north of 10, sometimes 11 CPR. We could be pushing 5 or lower. It's going to be pretty damn low. There's no -- unless something changes, it's going to be -- we're going to retest the lows, probably the lowest ever turnover rate is going to happen in the next year is my guess. And there's really deep discount coupons. We don't own any 2022 production and have a fair amount of '20 and '21 production, which still has ample amount of home price appreciation baked into it. We'll see if that holds. But they have -- they've surprised to the fast side for me personally. I think the Street's kind of pretty dialed in, but -- so I don't see valuations really being whipping around much as a byproduct of speeds coming down. But just from our point of view, I think that with mortgage rates as high as they've been a lock in as pronounced as it's been kind of surprised that we should continue to see double-digit speeds on some of our pools and hedges.

Yes. We still see production like $2 billion to $2.5 billion a day. That's surprising to me. I don't really see how it's staying as high as it is, but it is. I mean, it's very consistent, persistent, we'll see.

(Operator Instructions) And at this time, there are no further questions. I will now turn the call back to Mr. Cauley for any closing remarks.

Thank you, operator. Thank you, everybody, for taking the time. If anybody comes up with a follow-up question or you just happen to not make the call and listen to the replay and you want to ask a question, feel free to call the office. The number is (772) 231-1400. Otherwise, we look forward to speaking to you at the end of the fourth quarter. Have a great weekend. Thank you.

This does conclude the Orchid Island Capital Third Quarter 2022 Earnings Conference Call. Thank you for your participation. You may now disconnect.