Franklin BSP Realty Trust, Inc. (FBRT) Q2 2014 Earnings Report, Transcript and Summary

Good morning, and welcome to the Capstead Mortgage Second Quarter Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Lindsey Crabbe. Please go ahead, ma'am.

Good morning. Thank you for attending Capstead's Second Quarter 2014 Earnings Conference Call. The second quarter earnings release was issued yesterday, July 30, and is posted on our website at www.capstead.com under the Investor Relations tab. The link to this webcast is also in the Investor Relations section of our website, and an archive of the webcast will be available for 60 days. A replay of this call will be available through September 30. Details of the replay are included in yesterday's release. With me today are Andy Jacobs, President and Chief Executive Officer; Phil Reinsch, Executive Vice President and Chief Financial Officer; and Robert Spears, Executive Vice President and Chief Investment Officer. Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management. For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website. The information contained in this call is current only as of the date of this call, July 31, 2014. The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that, I will turn the call over to Andy.

Good morning, and welcome to our second quarter earnings call. And as Lindsey said, Robert and Phil are joining me, and after a few opening remarks, we'll open it up for some questions. Yesterday, the Federal Reserve Open Market Committee announced again it would continue to taper. Their purchases of treasuries and agencies are now down to $15 billion and $10 million -- $10 billion, respectively. And I think the more important part of that is they will continue to make -- repay -- they will reinvest the payoffs on a monthly basis, which has been averaging about $15 billion to $20 billion each month. So even as they wind down and taper their purchases, the -- reinvesting the runoff is still going to be significant, and that's expected to continue for quite a while. With the taper and all that, I mean, the Federal Reserve didn't focus on our type of securities that we buy, so it's -- it doesn't -- it isn't expected to have any significant impact to what we do in our securities overall. With the taper and everything going on, the 10-year treasury rate at the beginning of the year was 3%. It ended the second quarter here at just above 2.5%. And I think currently, today, it's around 2.60% after that Fed made their announcement yesterday. Now talking about the second quarter operating results. Net income was $36.6 million or $0.35 per common share. This compares to $38.4 million or $0.37 in the first quarter. We declared and paid a common dividend of $0.34 for the second quarter. Our net interest margin has declined to $39.5 million, as financing spreads declined 8 basis points, averaging 122-basis-point spread for the quarter. Yields on our investment portfolio accounted for all the decrease in financing spreads, driven by a $2.9 million increase in the investment premium amortization, as our prepayment rates increased from -- increased to 17.22% CPR from 15.16% CPR in the first quarter. Our borrowing costs were basically unchanged for the quarter. Our 30-day repo rates actually declined 2 basis points, averaging 32 basis points. However, this benefit was offset by a greater percentage of interest rate swaps moving into current-pay status. Our operating costs, as a percent of long-term investment capital, averaged 80 basis points during the quarter. This compares to 96 basis points during the first quarter. Regarding the portfolio. Portfolio acquisitions totaled $852 million, while portfolio runoff for the quarter averaged $693 million. We ended the quarter with an investment portfolio of $13.7 billion. 57% of this was invested in the current-reset ARM securities. Although the acquisitions exceeded runoff by almost $160 million, our leverage was unchanged at 8.52:1 for the quarter. This ratio was unchanged primarily because our long-term investment capital increased by $23 million during the quarter. Half of this was associated with -- we issued $12.5 million of our new 7 1/2% Series E preferred stock through our at-the-market continuous offering. And then the other part was associated with higher pricing levels for our investment portfolio, offset by declines in swap values. Now just a few final remarks. We're continuing to see lower repo rates in July, which could, if they persist, offset modest upward pressure on borrowing costs from additional forward-starting swaps moving into the current-pay status, similar to what we saw during this recent quarter. We anticipate manageably higher mortgage prepayment rates during the third quarter, due primarily to the continuation of the summer selling season and a reasonably strong housing market. We expect mortgage prepayment to again moderate in the fourth quarter. Overall, these are favorable conditions for prepayments and borrowings and conducive to generating satisfactory returns for the remainder of the year. And with that, I'll open it up for questions. Frank?

[Operator Instructions] First question comes from Steve Delaney from JMP Securities.

And Andy, especially the 80 basis point expense ratio, I think that's probably a record for -- low for a mortgage REIT in the 12-plus years I've been following this space. So great job on that. Things are obviously in a -- you guys are in a pretty good situation right now, I mean, in terms of speeds and funding costs and all. I'm just trying to think out -- look out over the next year. And I want to throw out a scenario and see how you guys react to this. We're at about 58 basis points on 1-year LIBOR now, maybe up like 3 or 4 since June. I've noticed the last couple of quarters -- the last few years, you've been living with this constant rolldown of the average coupon on your short reset ARMs. But it seems to have sort of stabilized here around 2.38%. I'm looking at the forward spot rates for 1-year LIBOR. And I look out to next March, I see 82. And next June, I see 106. And in June next year, maybe 50 basis points higher there. So what I'm wondering is, if you guys see a possibility where we could actually see LIBOR rates start -- especially sort of that 1- to 2-year range, if we could see 1-year LIBOR starting to move up well ahead of when the Fed is actually -- begins to do anything. And it seems to me, there's a possibility you're actually going to see a wider spread over the next 9 to 12 months, before you have to begin to deal with whatever Janet Yellen does sometime in late 2015. Just curious if you guys see that scenario is possible for your spread over the next year.

I'll make a couple of comments, and then I'll let Robert answer it more technically. But we're very hopeful of that. That's the design of our portfolio for that raising rate environment. We haven't -- we probably could have stepped back a year ago and looked at this and probably come up with the same sort of the numbers. It has continued to be in this range for a long period of time in the past. And we're hopeful that what you're saying would be correct, and then we would see our portfolio, which -- our current-reset portfolio at 12 months from now, theoretically, could be higher if your -- if those assumptions are correct. And Robert, do you want to add anything?

No. I think that's absolutely correct. I think you're right. I think LIBOR will lead -- will rise in anticipation of the Fed raising rates. At the same time, our swap costs will go up some, and if we decide to do longer-term repo, that'll be a little higher as well. But I think the portfolio's positioned very well for that type of environment where people are anticipating rates going up and the Fed continues to a stay little behind the curve, if you will. So I think that's a very distinct possibility.

Okay. And that kind of leads me to -- given that potential environment, you guys are enjoying the benefit of your stock trading at or above book, which is unusual these days for a residential mortgage REIT. About -- as far as capital raising in the second quarter, I saw you did the small amount of it, the new preferred, but I was kind of actually expecting you might tap the ATM plan a little bit on common, just the given that -- the fact that for most of the last 3 months, it -- the stock has been well over $13 and you printed the $12.69 [ph]. Just curious if you saw blocks of bonds that are attractive and maybe that there is the challenge, Robert. But curious if you would consider using -- doing a little common through the ATM plan if the opportunities came up to find the right bonds?

Yes. I mean, I think if the supply's out there and there's an -- if ARMs widen, let's say that tapers and fixed rates widen and then ARMs widen in sympathy with that, and we're trading at a premium to book, sure, I think we'll look at something like that, absolutely.

Yes. I think as you all heard me say before, the discipline with the way we raise capital is we're not going to do it just to build our platform. We're going to do it when we can deploy the capital at accretive levels. And it's just not a compelling trade to raise capital at this slight premium. So we're just -- we're content at this point to raising the money at the -- and through our Series E at 7 1/2% coupon is a better cost to capital for us than raising it in the common space at this point. So we were content with that, but we do look at it.

Next question comes from Joel Houck from Wells Fargo.

So just maybe a comment on -- I think I heard you say on the prepared remarks that you expect prepayments to moderate. That implies that this is more kind of transitory or seasonal. Can you overlay kind of comments on the net spread and perhaps kind of how you see that playing out between now and the end of the year?

Well, I think we already have the first trend of the third quarter. And I think generically, ARM speeds are up roughly 2% CPR from 17-ish to 19-ish. And I think most prepayment models have speeds maybe going a little higher than that in the following month and then coming back down. And then in the fourth quarter, they should decline further. And obviously, that's also contingent on what rates do. But as these levels are higher where fixed-rate mortgages are, I think that's probably going to bear out. And obviously, as speeds comes down, our spreads improve and vice versa.

Yes. I think the summer selling season and housing values -- HEP [ph] values as they are, August is probably going to be, we think, we believe, and I think the market, as Robert was quoting, believe that August is probably going to the highest print here, and that from there, we'll start to see things taper back off from that because we get it back into -- kids go back to school. And so we think that's really what's going to happen and that's what the market expects. And I think if you look at the quarter-over-quarter with the increases in CPR that we saw this period, we saw a little over 2% CPR, whereas we saw the decline in the previous quarter by about 2% CPR. And I think just very simply, the math here is that every 1% CPR in average increase or decrease ends up being about $1 million to $1.5 million in earnings associated with it, with additional amortization. And that's pretty much what you saw in the second quarter. You saw almost a $3 million -- $2.8 million increase in 2% CPR. Whereas the previous quarter, it declined about $2.5 million from the December quarter, which was also associated with the 2.2% change in CPR lower. So it ranges in there. Composition changes that. But that's pretty what -- pretty simply what the math is from the back of the envelope type analysis.

Okay, that's actually very good color. And then maybe if you could comment on the -- what returns look like on stuff that you're replacing? Obviously, prepaid runs off, I mean, is that -- is it a little differential now, accretive, slightly dilutive? Or how should we think about that?

We were probably getting close to 125 basis points in spread, which, if you lever that 8.5x, that gets you kind of between 12% and 13% on new investments at the margin?

Okay. So that would imply it's slightly accretive?

Yes.

[Operator Instructions] Next question comes from Mike Widner from KBW. Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division: Honestly, I think most of my questions have been answered, pretty straightforward quarter. I guess, maybe the one thing I'll just ask for a quick comment on since I got the line is you raised a little capital. Obviously, that makes you buy new investments. You're not buying current-reset ARMs. You got to buy sort of the longer-dated ARMs and let them roll down. And so where I'm heading with that? If I look at your mix of current-reset ARMs versus long-reset ARMs, it's been actually pretty darn stable over the past 8 quarters or so. You're right around 57% in the current-reset. And I mean, is that sort of a target of yours, or is that just kind of the way it works out? Or I mean, how should we think about that mix?

It varies over time. And obviously, it depends upon what we can purchase. And you're right, we've been buying more longer-reset ARMs. Though what happens, the reason why these percentages are staying constant is because we have paper rolling down into the shorter reset bucket on a monthly basis. And so even though we've been buying closer to 80% to 90% longer resets, the ratio hasn't really moved. And also helping that composition is the fact that the longer resets prepay faster than the shorter resets because the shorter reset are very seasoned. And so yes, I mean, I think we kind of like that mix kind of in anywhere from 50% to 60% in the shorter reset buckets. But as we've talked about before, it's very difficult to buy that paper right now and make it work on a levered basis. So by default, we're kind of moving out the curve a little bit. Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division: I guess what surprised me is the stability of that mix, because like you said, it's -- to go out and try and buy a current-reset ARM economically doesn't necessarily work in a mortgage REIT. But yes, I mean, the prepays and everything have come in such that the mix has been pretty stable and...

Yes. If you look at our longer-reset securities, they have an average 39 months to roll, so we don't stratify it by 15 to 20 months or whatever in our earnings release. But if it -- there's just always a nice chunk every month that is rolling down from the longer-reset bucket to the shorter reset bucket. Michael R. Widner - Keefe, Bruyette, & Woods, Inc., Research Division: And then really, I guess, the -- my question was is that sort of some -- because when you go out and replace runoff, you can buy something that's 70 months to reset if you want to or something that's 36 months or even 20 months. And that's what I was sort of wondering at is -- do you pick your investments to sort of maintain that balance of somewhere in the mid-50s of -- percentage-wise of current-reset ARMs?

Yes, we're trying to. And still, we really aren't buying longer than [ph] 5-1s. And so we're buying a combination of new issue. We're also buying season paper that's -- we might be buying season bonds that are 30 months or older, et cetera. But yes, we take that into account. And mainly, we're trying to stay within a certain duration and keep our duration gap short right now. So yes, I mean, we look at that percentage on a regular basis.

Well, just kind of layering on with Steve Delaney's comment earlier about raising capital, as I said -- if we can deploy the capital on a short-term basis in a short [ph] period of time, we look at it. And I think that our ratio between current and longer to reset is if we had an opportunity to bite, issue some capital and invest it, that -- you could see it move that way because we're -- predominantly, you're going to be buying longer reset, as Robert's saying. So if we raise a sizable amount of capital, it probably could be deployed into the longer reset and the current basis. But other than that, it's just kind of ebbing and flowing as we're going through here.

At this time, we have no more questions. This concludes our answer-and-question session. I would like to turn the conference back over to Lindsey Crabbe for any closing remarks.

Thanks, again, for joining us today. If you have any further questions, please give us a call. We look forward to speaking with you next quarter.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.