ARMOUR Residential REIT, Inc. (ARR) Q3 2019 Earnings Report, Transcript and Summary

Greetings, and welcome to the ARMOUR Residential REIT, Inc. Third Quarter 2019 Earnings Conference Call. During this presentation are in a listen-only mode. Afterwards, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded on Thursday, October 24, 2019. It's my pleasure to turn the conference over to Jim Mountain, Chief Financial Officer. Please go ahead, sir.

Thank you, operator, and thank you, all for joining our call to discuss ARMOUR's third quarter 2019 results. This morning, I'm joined by ARMOUR's co-CEOs, Scott Ulm and Jeff Zimmer; Mark Gruber, our COO and CIO. By now, everyone has access to ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website, www.armourreit.com. 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 these forward-looking statements, due to the impact of many factors beyond the control of ARMOUR. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic report filed with the Securities and Exchange Commission. Copies are available on the SEC's website at 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 measure. A reconciliation of these measures with the most comparable GAAP measure is included in our earnings release, which can also be found on 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 Q3 GAAP net loss was $61 million or $1.09 per common share. The net loss was driven primarily by $81.2 million of adverse mark-to-market movements of our interest rate swaps, while the favorable $93.9 million mark on are available for sales securities flows through other comprehensive income. Our core income which excludes those mark-to-market items, but includes TBA dropped income was $35.9 million or $0.55 per common share. For the last 13 quarters, our quarter earnings have consistently exceeded dividends. Looking forward, we also expected for the full year of 2019, core income will exceed dividends. Through September 30 that excess totals $42 million, which represents about $0.71 per common shares outstanding at quarter end for those 13 consecutive quarters. Based on stockholders' equity at the beginning of the quarter, core income represents an annualized ROE of 10.4%. During the quarter, we repurchased 330,000 common shares of ARMOUR stock for $5.6 million. That added $0.02 per share to our book value. During the quarter, we completed the redemption of $54.5 million of our 8.125% Series A cumulative redeemable preferred stock, which we have previously announced in Q2. We've also issued 696,479 shares of our 7.875% Series B cumulative redeemable preferred stock under our preferred B ATM sales agreement. ARMOUR quarter end agency portfolio consists of over $12 billion of mortgage backed securities. Quarter end book value was $20.43 per common share, 0.3% for the quarter. As the positive impact on book value for rates was fully offset by the impact of spreads and pay downs, reflecting our losses on interest rate contracts and partially offset by gains on the agency securities. Net of hedging, the excess core income and over our dividends paid also contributed. GAAP book value at October 22, 2019, was estimated at $19.76 per common shares outstanding. Remember that we include recent book value estimates in our update presentations available on our website or EDGAR, usually around the middle of the following month. We paid dividends of $0.17 per common share during each month in the third quarter for a total of $30.3 million or $0.51 per common share. We've announced monthly common dividends for October and November at the rate of $0.17 for common share. Now I'll turn the call over to Co-Chief Executive Officer, Scott Ulm to further discuss our portfolio position and current strategy outlook.

Good morning. The global economic concerns and heightened uncertainty around fed policy from the first half of 2019 continued into the third quarter and still exists today. Despite delivering on 25 basis point cuts in the third quarter, the Federal Reserve remained non-committal to a deeper using cycle, citing low unemployment, strong consumer housing data and the stable GDP, one of the more on October 30, but the market clearly expects more from the fed. The markets concerns around it for long trade war weakening global manufacturing and stagnating prices have been manifested in lower Treasury yields, higher bond volatility. Note that on December 31 of last year, the U.S. Treasury 10-year note yielded 2.68%, got as low as 1.46% on September 3, then within 10 days jumped to 1.9% before settling in today's mid 1.7% type of yields. Additionally, the spread between yields on three-month LIBOR in the 10-year Treasury, a common measure for the health of the financial system tumbled from negative 66 basis points also on September 3, underscoring the diversion between the markets pricing and the feds own outlook. Today, the spread stands at circa negative 20 basis points. Note that the average for the preceding 12 months was negative 11 basis points. We anticipate the Federal Reserve committee to follow-up with at least one more 25 basis point decrease in overnight borrowing cost by the year's end. Federal funds futures indicated 89% chance of a 25 basis point rate cut in October. The mortgage refinancing machine reach full speed by August is measured by the MBA refinancing index touching levels last seen in 2016. The average prepayment rate on our agency assets increased from 7.3 CPR in the second quarter of 2019 to 13.3 CPR in the third quarter. Given the current level of mortgage rates and available capacity to originate new loans, we project speeds to start receding by early next year as borrower burnout and seasonal factors mute the fastest of speeds. We note that over 80% of our agency portfolio is prepaid protected through superior assets characteristics to those of TBA or generic new production bonds, which are the most risk to refinance. A precipitous drop in mortgage rates raised expectations for significant supply of new MBS and faster mortgage prepayments, resulting in a drastic reduction of MBS durations and wider spreads. Despite an increased volatility and worsening negative convexity of MBS, ARR have maintain a positive average duration gap of plus 0.4 throughout the third quarter to meaningfully offset any losses coming from spreads income and convexity. In the third quarter, ARR's agency MBS stock holdings widened by 11 basis points in option adjusted spread. The agency DUS portfolio during the third quarter saw more modest widening of 3 basis points, where the positive convexity contributes a significant diversification to the portfolio. Similarly, our non-agency and CRT holdings also widened by just 3 basis points during the third quarter. Although inter quarter volatility and spreads presented us with several opportunities at season CRT advantages when the market prepayment fears exceeded our own projections. A technical drop in broader United States banking and financial corporation’s available liquidity reserves in mid-September, saw funding markets experience their first real big challenge in a decade. Of September 17, MBS reports a high on 10% and averaged over 6% for the day. Concerns around the quarter and year and funding emerged and the fed quickly responded by injecting liquidity via sizable reverse repo operation. Although we saw our counterparts raise rates during this period of heightened volatility, our affiliated broker dealer BUCKLER Securities was able to provide a stable financing alternative. This is exactly the situation for which we created BUCKLER and it served us very well in these volatile circumstances. In the third quarter, mortgage spreads have continued to lag those and securitized credit, highlighting concerns around gross and net supply volatility, as well as negative complexity embedded in the sector. At current valuations, the risk reward owning MBS is clearly moved towards attractive territory. Mortgage backed securities OAS has reached wise last seen three years ago. The beginning of the fourth quarter saw further winding with OAS jumping 9 basis points and swap rates widening by 12 basis points. Overall, we look to yield curve normalization and the decline in rate volatility is necessary signals for outperformance in the sector in 2020. Despite the volatility of the current environment, we remain constructive on our prospects to create value for our shareholders and expect that our year 2019 core earnings will exceed our dividends declared and pay. Some of the factors we have to deal with should abate in the coming months, prepayments burnout, the fed realizes the issues with repo and is taking concrete and substantial steps to stabilize the market. The trend in short term rates is down suggesting we will see a more positive yield curve for our investments in funding, particularly if repo rates behave more normally. And the spread environment is historically wide. Taken as a whole, these factors suggesting the overall improving environment for our business. Operator that concludes our prepared remarks. We will now take questions.

Absolutely sir. We will now begin the question-and-answer session. [Operator Instructions] And our first question comes from the line of Douglas Harter with Credit Suisse. Please proceed with your question.

Thanks. Could you talk about your expectations for how much more your pre pay speeds might increase in the fourth quarter?

Sure. And that's probably – Doug, it's Jeff. It's probably part of a broader question regarding NIM, which you know, we get from investors and analysts when they call the office. So we'll talk about that. We expect the November prepayments to exceed October prepayments by between 5% and 15%. And we're zeroing in on the middle of that range. We expect prepayments thereafter to drop from those levels due to capacity constraints that Scott talked about in his comments a couple minutes ago investor burnout in other words, refinance burnout, I think it's a better way to say that. And then the third element of that is the mortgage rate, you know, hovered around 361 for quite a while. It's between 382 and 386 today depending on which source you look at. So you will see prepayments normalize as we move into the first quarter. Now of course, you could see them get way slower, rates go up a little bit more, and you can see them get faster of course the rates go down a little bit more. So looking at NIM, if you want to move on to a more holistic question, I think they'll be four components to a positive perspective on NIM looking out over the next couple quarters. Prepayments normalizing, which I just discussed. The fed rate cuts will help the curve is deepen, and in turn will help repo normalization. And you know, repo rates are trading higher than fed funds rates based on historical. So the fed funds target was 175 and repo should be closer than about the two to 205 areas that were trading depending on the tenor. And then the fourth thing is OAS has widened out a lot, zero OAS on June 19 were 52 basis points current coupon, which is like a 2.5 or 3 depending on your date, okay. They're 98 yesterday, big widener. So they provide some opportunities. So despite the fact that there was, I've noticed in your report this morning, the book value change in the fourth quarter, 2.5 the current coupon widens 3 OAS since the end of the quarter. However, the ARMOUR portfolio widen 9 OAS. And I would suggest that the book value change in the fourth quarter so far would be 85% of that is spread and 15% of that the increase in rates. If you look at our monthly company update, you can see that the average net coupon the 30 assets is a 4%, see if like a 460, 462 gross rate. So those are the assets that performed, you know, underperformed over the last couple weeks. So when you're looking at doing the analysis, don't look at what the broker says the current coupon is doing because that's going to trade like a treasury for a while it has a 99 handle on it. So anyway, that's a long answer to your short question. Thank you.

Great. And then just sort of still within, you know, the spread question. You know, you mentioned a little bit about BUCKLER securities. Can just talked about, you know, kind of how you see funding differentials between BUCKLER and street repo today?

Yeah, Doug, BUCKLER's funding is, you know, I'd say broadly consistent with the street, sometimes a little better, sometimes a little wider, depends on the day, depends on the market. The principal difference taken as a whole though is, we are comfortable having funding open overnight with BUCKLER, something we wouldn't do with a third party where we live by the grace of them granting us balance sheet. We're having confident BUCKLER's ability to fund and the ability to have open, you know, really gives us the opportunity to execute on opportunities that appear in the market, which we wouldn't have if we were, you know, say turned out 30 days at a time. So there's a very interesting sort of option to that. And, you know, while it hasn't been true with the inversion in funding markets, open, in quotes, normal times often offers a pretty substantial funding advantage too.

Great, thank you.

Thank you, sir. Continuing on, our next question comes from the line of Trevor Cranston with JMP Securities. Please proceed.

Hi. A couple questions on the repo market. I guess the first part is, can you say if you think that the spike was, I guess in mid-September had any, you know, measurable adverse impact on third quarter results? Specifically, I'm thinking of, you know, look like leverage kind of ticked down over September. And I was wondering if that was related to, you know, possibly not wanting to roll repo at higher rates? And then second part of the question is kind of how you guys are thinking about the repo market, heading into year end and if you're, you know, approaching that any differently than normal, and you know, maybe preemptively looking at extending repo across your end? Thanks.

So I'll echo Scott's comments on the power of having our own affiliated broker dealer. We have a third of our book right now already well into January 2020, because we have our own broker dealer, we're always confident of getting overnight funding. We've maintained about two thirds of it on a shorter scale. And of that two thirds of, you know, 65% I think with BUCKLER. As we get into the fed moves there and we look at what things do over the year, we will slowly kind of move out, but not the entire book. We're very comfortable having always access to the FICC that most other REITs just don't have. Now in terms of your first question was normalizing on repo, repo should trade tighter to fit funds, then – it should trade in tighter now because it has trade tighter in the past. The over year end situation being like the September 16 and 17 situation, we do anticipate some dislocation, but we're very comfortable with the structure that we have to be able to solve any problems with that dislocation. And the earnings effect of the September 16, 17 is so negligible, it's not even worth bringing up way, way less than a half a penny.

Okay, gotcha. So, would you say the sort of half turn drop in leverage, is that just sort of normal portfolio management or is that kind of level you guys are anticipating running at for the fourth quarter?

I talked about it on the last earnings call and I'll repeat it again. So even though it looks like we only bought 5.6 million back of ARMOUR stock in the third quarter, we bought 54.5 million back of the Series Preferred A. So if you take that kind of times, nine times leverage that $500 million worth of reinvestment we did not have to make. We felt the mortgages were going to widen, we said so in the last quarterly call, mortgages have widened, we've let our portfolio run off. We now have dry powder, and we may opportunistically as we see what the fed does here and that curve maybe deepens a little bit, put some money to work in agency mortgage backed securities. As I said, they're the widest zero LOS spreads they've been in three years. So you might see leverage go up a little bit from where we are right now, but certainly not more than a turn. And we may finish the end of the quarter just where we are right now if we don't find the right entry point.

Gotcha. Okay, that's helpful. And then in terms of how you guys are approaching interest rate risk management, can you comment on how you would expect the portfolio to perform, you know, an upgrade scenario versus a downgrade scenario and generally, kind of how you think about the balance of those two risks and the extension risk within the portfolio? Thanks.

We have many charts that show what our book value does, and how our portfolio performs in up and down markets. And you know, it's pretty even between 25 basis points up and 25 basis points down. So you just have a nominal movement book value. But when we do those charts, they don't account for the fact that the mortgage book written in 1978 says the mortgage is supposed to tighten when rates go up, but they didn't do that in the first three weeks of the fourth quarter. And generally, though, they would. The reason they didn't is because there's still heightened awareness of heavy prepayments, which put pressure on, you know, things like 3.5 coupons that have 460 gross wax on them, which is kind of what the new TBA origination is right now.

Okay, gotcha. I appreciate the comments. Thank you.

Thank you.

Thank you. Continuing on. Our next question comes from the line and Christopher Nolan with Ladenburg Thalmann. Please proceed.

Hi. Thank you for taking my questions. What's the thought process right now for additional share repurchases in the fourth quarter?

We're trading quite a bit under book and we will selectively buy back shares. Remember, we just spent $60 million in the third quarter, which is quite a bit of money and we'll be selected but we'll buy back shares. I think has been – you know, it's funny, it's accretive and not as much as you think. And to make like ridiculously accretive, you got to spend so much your cost ratio starts to go up. So we'll buy back. It's good for shareholders. It's accretive to book value. And we will continue to do so for this kind of discuss.

Okay, and just following up on Trevor's question on the leverage. Am I interpreting correctly that you're not really expecting much in the way of a change in leverage, I mean, it all depends on if you see an attractive entry point, but it sounds like you're trying to position the portfolio just to maximize your options sometime in the next two or three quarters? Is that a fair way to looking at it?

Yes. And to be further to that point, just to reiterate, we bought back the Series A preferred, so we didn't have to reinvest for essentially the last three to four months in a period where we expected mortgages to widen out, we had a proclivity toward widening. So now that risk is been avoided. That's why our book value performance in this quarter was so good versus what we believe expectations were. We will only increase our leverage if we see some good opportunities. And remember, it's just not LOAS is just not OAS, it has to be between OAS, where the hedging opportunities are as well as where the funding rates are. So if we get that holistic opportunity, we'll go ahead and spend some money and you could see leverage go up now. We have not reinvested as I said, for the last couple of months. So the first thing we'd be looking at is do we want to reinvest for November or December paid out before we would even be taking up leverage. So I hope that's helpful.

Great, thank you.

Thank you. [Operator Instructions] Our next question comes from the line of Matthew Howlet with Instinet. Please proceed with your question.

Thanks for taking my question. Good morning. Just Jeff, you talked about some positive guidance in terms of possibly next year margins are improving or the outlook improving. I just want to follow-on that. I know you don't get margin guidance, but could the margin sort of bottom here in the second half of the year and sort of beginning proving next year that sort of had to think about the trend in margin?

This is what we see is the future. You should see some sort of bottoming here I was thinking though in the fourth quarter. If the elements that are very positive that we discussed for some reason don't realize all of a sudden 10-years is 115 10-year, the fed doesn't cut, curve gets inverted. Those are things we don't expect to have happen. But if things that we expect to have happen, which are very realistic propositions that would be our thought that you should NIM bottom out in the fourth quarter, perhaps the first quarter.

Got it. Okay. And then I like you talked about value in the mortgage backed market. I was wondering, are we talking about specified pools, are there certain areas in the pay up that you see more value and then in certain areas other than other areas, just curious on that on your outlook?

I want to be careful here because we are doing some reinvesting pay downs right now. We did spend a few hundred million dollars in the last few days in one area of the specified market. We look at it versus everything. Dollar roles, which may kind of look good to some people, in some respects are not good versus specified pools. Some specified pools are trading two points over TBA. Those are pools that we would have bought a year ago at you know, up 8 and 12, we don't buy those anymore. But there are certain areas that we believe are modestly undervalued do not cost so much more than TBAs that we look as good investments with nice convexity features.

Got it. And then I noticed a short TBA decisions, is that something we expect to be ongoing part of the portfolio, you know, looking out?

Yes, the short TBA position represents some higher coupon assets, that if the market rallied against us. We have assets that aren't performing well that we could deliver into that otherwise – so it's an inverted role curve. So think about this. Normally, you're a mortgage banker and you're selling your threes and two and out in the future, okay and you're selling them at you know, 102 in September and in October they're 101.24, November they are 101.5. If you look at fours in particular, the fours are inverted because people expect high prepayments and poor performance. So you can sell out 2, 3, 4 months, in theory at higher prices, that gives you an opportunity to put on the kind of trade we do. And it's a big market enrolls. We know everybody else knows that. But now just to be clear of the type of thing that you could see us do when things get a different than has been typical.

Great. Got it. I think that's it. Thank you.

Thank you. I'll now turn the presentation back to Mr. Mountain to continue your presentation for your concluding remarks. Thank you.

Thank you, operator, and thank you, everybody for joining us. As always, we appreciate your interest in ARMOUR Residential REIT. And if you've ever got any questions, please feel free to give us a call at the office, we'll try and get back to promptly. We'll talk to you next time.

Thank you, sir. And that does conclude the conference call for today. We thank you all for your participation. And you please disconnect your lines. Thank you once again. Have a great day.