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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning. I'd like to welcome everyone to the Arlington Asset First Quarter 2018 Earnings Call. [Operator Instructions]. I would now like to turn the call over to Rich Konzmann. Mr. Konzmann, you may begin.
Thank you very much and good morning. This is Rich Konzmann, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I'd like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations and any other guidance on present or future periods, constitute forward-looking statements that are subject to a number of factors, risks, uncertainties that might cause actual results to differ materially from stated expectations or current circumstances.
These forward-looking statements are based on management's beliefs, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or factors.
These and other material risks are described in the company's annual report on Form 10-K and other documents filed by the company with the SEC from time to time, which are available from the company and from the SEC. And you should read and understand these risks when evaluating any forward-looking statement.
I would now like to turn the call over to Rock Tonkel for his remarks.
Thank you, Rich. Good morning, and welcome to the First Quarter 2018 Earnings Call for Arlington Asset. Also joining me on the call today are Eric Billings, our Executive Chairman; and Brian Bowers, our Chief Investment Officer. Before discussing the specifics of Arlington's results for the quarter, I would like to begin by providing some overall market commentary. After a relatively calm environment and low volatility last year, the first quarter saw a reversal of that trend as interest rates rose significantly and equity markets weaken, leading to heightened levels of volatility.
The Federal Reserve raised the target federal funds rate by 25 basis points in March, while also affirming its commitment to its balance sheet normalization policy and further gradual increases in the target federal funds rate. The 10-year U.S. Treasury rates rose 33 basis points during the quarter to end the quarter at 2.74%, while the Treasury rates curve continue to flatten as the spread between the two-year and 10-year U.S. Treasuries narrowed five basis points, with the short end outpacing the long end of the curve. Increased volatility along with market concerns related to the increased net supply of agency MBS as the Federal Reserve executes its quantitative tightening policy lead to a widening of agency MBS spreads relative to benchmark interest rates and resulted in underperformance in the pricing of agency MBS relative to interest rate hedges. With rising interest rates and spread widening, longer duration investment portfolios were penalized somewhat during the quarter. A reversal of the trend we saw last year.
In the first quarter, funding dynamics for repo financing improved during the quarter, and in particular, in March. The spread between three-month LIBOR and repo rates widened significantly as three-month LIBOR rose 62 basis points. While repo funding rates generally only rose in correlation to the 25 basis points federal funds rate increase, this funding dynamic reduces the net funding cost of repo financing hedged with interest rate swaps.
Overall, prepayment speeds in the residential mortgage market were lower than the prior quarter, driven by higher mortgage rates and normal seasonal patterns, leading to higher asset yields.
Looking forward, near-term prepayment speeds are expected to remain moderate due to the current interest rate environment, providing for, of course, for a normal seasonal impact.
Turning to our actual results for the quarter. We reported a GAAP net loss of $2 per share, which includes $0.64 per share deferred tax provision, resulting in a pretax loss of $1.36 per share. Our pretax loss includes a net investment loss on our investment and hedge portfolio, reflecting the widening of agency MBS spreads and rising interest rates during the quarter.
Non-GAAP core operating income was $0.57 per share, a decrease of $0.01 per share from the prior quarter. Core operating income compared to the prior quarter was impacted by higher investment yields, driven by lower prepayment speeds and reinvestment at higher yields, offset by slightly higher average fix pay rates on the company's interest rate swaps as the company added duration to its swap hedge portfolio, lower net interest spreads on the company's TBA dollar rolls, and modestly lower investment volumes.
Tangible book value, defined as GAAP common equity excluding our net deferred tax assets or liability, was $11.65 per share as of March 31, including the company's $0.55 per common share dividend. Total economic return for the quarter was a loss of a 9%. As of quarter end, our GAAP book value was $11.03 per share. Book value declined during the quarter mostly due to spread widening, leading to the underperformance of our agency MBS relative to interest rate hedges, as I've described, and the recording of a deferred income tax provision, which I'll discuss in a bit.
The weighted average CPR for our specified agency MBS during the quarter was 8.64%, a decrease from 9.55% in the prior quarter, contributing to an increase in the weighted average effective asset yield on our agency MBS, up 2.98% compared to 2.86% last quarter, the increase in the company's weighted average asset yields was also driven by the repositioning of the investment portfolio into higher coupon securities over the last two quarters at higher current investment yields.
The higher weighted average asset yields contributed to an approximately $0.04 per share increase in core operating income during the quarter. Looking forward, prepayment fees increased slightly to start the second quarter, with a weighted average CPR for April at 9.15%, which we expect would result in a weighted average effective asset yield of approximately 3.03% for the month.
The company carries a substantial interest rate swap hedge position that serves two primary purposes. First, our interest rate hedges mitigate the impact of rising interest rates on the value of our fixed-rate agency MBS portfolio. Second, our interest rate swap position converts a substantial portion of our repo funding from a variable to a fixed rate for the life of the interest rate swap. As of March 31, the notional amount of our interest rate swaps was 98% of our outstanding repo funding balance.
In addition, the total notional amount of all our interest rate hedges consisting of interest rate swaps and U.S. Treasury futures was 87% of our outstanding repo funding and TBA purchase commitments, with our net duration GAAP standing at neutral net zero years as of quarter end.
Our interest rate swap position is constructed to generally match the expected life of our current agency MBS portfolio, financed with repo funding for approximately the next eight years. To illustrate this point, we've provided a chart on Page 8 of our first quarter investor presentation, showing the matching of our agency MBS portfolio compared to our interest rate swap position for the next several years. We believe our interest swap hedge position helps mitigate the impact of rising interest rates on our spread earnings by effectively locking in to a spread on a substantial portion of our investment portfolio.
Accordingly, the impact of rising interest rates and changes in agency MBS spreads on the future spread earnings of our current investment portfolio is generally linked to the amount of monthly pay-downs on our agency MBS portfolio that is reinvested at then-current spreads as well as the rolling of our TBA position, which is repriced each month at the then-current spreads, plus portfolio size adjustments or other refinance we may undertake from time to time.
As a reminder, the company received three-month LIBOR on the receive leg of its interest rate swaps, which are reset every three months based on the respective reset date of each individual swap.
To the extent that three-month LIBOR increases at a faster pace than repo funding rates, the company's net funding rate declined.
As I mentioned earlier, three-month LIBOR rose significantly faster than repo rates during the quarter. And since most of that increase occurred in the later part of the first quarter, the benefit of lower - net funding rates in the company's core operating income during the first quarter was minor.
However, as the company's interest rate swaps are resetting at higher three-month LIBOR rates, the company's net funding cost should benefit to some degree in the second quarter.
For example, the spread between three-month LIBOR and repo funding rates as of March 31 widened over 30 basis points since year-end. During the first quarter, the company extended the duration of its interest rate swap portfolio, resulting in a modest increase to its weighted average fixed pay rate of its swaps, which drove an increase in the company's net funding cost for the quarter.
The company's allocation - capital allocation to long TBA positions relative to specified agency MBS increased slightly during the quarter. The implied net interest spreads available on TBA dollar roll during the first quarter continue to remain favorable compared to net interest spreads on specified agency MBS financed with repo funding, although the relative advantage of TBA roll declined during the quarter. The weighted average implied net interest spread on the company's TBA dollar roll declined to 1.84% during the first quarter compared to 1.98% last quarter and contributed to a $0.2 per share decline in core operating income.
As of quarter end, the company's agency MBS portfolio totaled $5.4 billion, consisting of $3.9 billion of specified agency MBS and $1.5 billion of net long TBA agency securities. During the first quarter, the company increased its allocation to 4% and 4.5% coupon 30-year agency MBS, while lowering its exposure meaningfully to 3.5% coupon 30-year securities to take advantage of expected higher risk adjusted returns in the rising rate environment. We expect this transition should result in the dual benefit of somewhat higher asset yields and reduce sensitivity in the rising rates.
The company also trimmed portfolio average balances somewhat during the quarter. The company continues to utilize its tax benefits supported to it as a C corporation to allow it to shield all of its income from taxes. As of quarter end, the company had estimated net operating loss carryforwards of $52 million, net capital loss carryforwards totaling $381 million, and AMT credit carryforwards of $9 million.
Based on its current investment and hedge portfolio, the company expects that it will utilize its net operating loss and remaining AMT credit carryforwards in the latter half of 2019, although changes to the composition and size of the portfolio on actual lower or higher than expected future income could change that estimate.
In addition to providing shareholders with a higher tax advantage dividend as compared to a similar dividend from a REIT, the company's C corporation structure provides the company with greater investment flexibility as well as the option to retain core earnings or reinvest opportunistically.
Finally, I would like to spend a minute expanding upon the company's deferred tax assets and liabilities reported on its balance sheet. While our REIT does not record its deferred tax assets or liabilities on its balance sheet, a C corporation like Arlington is required to record them on its balance sheet.
For GAAP accounting purposes, the company had a net deferred tax liability of $18 million as of March 31, compared to a net deferred tax asset of $1 million at the prior quarter end. To better understand the factors driving the changes to the company's deferred tax assets and liabilities, it is important to understand the difference in tax character between ordinary income and capital income and how these relate to the company's investments and hedge portfolio.
The company continues to carry a full valuation allowance against its deferred tax assets that are capital in tax character, and on the other hand, no valuation allowance against its deferred tax assets that are ordinary in tax character. As we have stated previously, the company enters into various hedging transactions to mitigate the interest rate sensitivity of its borrowing costs and the value of its agency MBS portfolio. For income tax purposes, gains and losses from its agency MBS are capital in tax character, while gains and losses from its interest rate swap hedges are ordinary in tax character.
During the first quarter, the company experienced net losses on its agency MBS that are capital in tax character for which no income tax benefit and related deferred tax asset were recorded since the company's valuation allowance against its capital deferred tax assets increased by a corresponding amount.
On the other hand, during the first quarter, the company experienced net gains on its interest rate swap hedges that are ordinary in tax character for which a deferred tax provision and related deferred tax liability were required to be recorded, resulting in the company now having a deferred tax liability on its balance sheet as of quarter end. For accounting purposes, our interest rate swaps are hedged against future higher funding costs on our repo financing for which the future higher expected funding costs are not currently reflected as a deferred tax assets, whereas the future benefits of the hedge against the higher expected funding cost embedded in the forward curve are currently recorded as a deferred tax asset.
Economically, if the forward interest rate curve embedded in the current gain on the interest rate swaps materializes over the life of the swaps, this deferred tax liability related to the future interest rates on those interest rate swaps would generally be offset over time by an equivalent amount of future higher interest payments on our repo funding.
Overall, hedged agency investment returns continue to remain attractive and the company remains committed to the interest of its shareholders and to deliver dividends which continue to support attractive, long-term returns to shareholders on after-tax adjusted basis.
Operator, I'd like - now like to open the call for questions.
[Operator Instructions]. Our first question comes from Doug Harter from Crédit Suisse.
This is actually Josh, on for Doug. First question, given the uptake and leverage we saw on the quarter, how are you thinking leverage at current levels? Will leverage be a limiting factor going forward that may prevent you guys from taking advantage of market opportunities? Or are you comfortable with where you are today?
Thank you for the question, Josh. So first of all, our portfolio has demonstrated, I think, that it's quite resilient over an extended period of time through volatile periods and pretty dramatic movements in rates and spread environments and curve shapes. So the portfolio is quite resilient, and the earnings stream from that is quite resilient - has demonstrated over time to be quite resilient as well. Having said that, as you, Josh, have heard and others have heard me say in prior period remarks, as we saw a trend in the back half of last year of declining leverage in the company, and as I think I said last quarter, in the absence of a particular market-turmoil-driven widener, people shouldn't be surprised to see - expect to see that continue. I answer - I would say the same today, which is that looking at the big picture, we realize - or fully realize that while spreads today were wider than they were two months ago and attractive on that basis, that on a broader perspective, we're in a - we've been in a flattening curve environment with the prospect of additional Fed activity on the front end of the curve and potential additional flattening in the curve as a consequence, a gradual over time tightening of new spread opportunities. And so for that and other reasons, I think, the observation and the remarks I've made in the past would hold, which is that in the absence of particularly volatile movements which occur, for example, like those that occurred during this quarter, people shouldn't be surprised to see the leverage - for us to consider bringing the leverage down over time.
Makes sense. Rock, and then just one - thinking about the cost of the funds benefit you're going to achieve from the widening of the LIBOR repo spread, when should we expect - do we expect the full benefit to come through in the second quarter? Or could that - some of that leak in the third quarter? And then do you have any expectations of this spread normalizing? Or is this more of like a structural change in your view?
Well, a couple of thoughts. First of all, as I think we and others have spoken about before, there have been moments in time over the last year or so couple of years, where you've seen at least temporary improvements in funding cost advantage for the space. And I suspect - I mean, we feel like this one will be a benefit that we have the benefit of for a period of time and then it'll sort of likely generally ameliorate over time. But structurally underlying this is - has been an important shift in the market for repo funding for this type of collateral, driven in part by the money market performance from a year and a half ago. And so that has driven a bit of a structural rebalancing of the base, the investor base for this. That's probably over time, sort of, got us a permanent structural benefit character to it. And so there's presumably some benefit there that will be ongoing and some benefit there that will be temporary. So it's hard to say what it might be down the road, but there should be some benefit in the second quarter to that.
It makes sense. And then lastly, can you give us an update on how your book value have fared this far in the second quarter?
Sure. So going in the last week - going into this week, I would have said that the book value was up, may be a point or so. And I'd say, given this week's activity, probably about flat.
And your next question comes from Trevor Cranston from JMP Securities.
Follow up on the question about leverage. Rock, in your answer, you mentioned that it would be reasonable to assume that leverage kind of was a bit lower over time. Can you expand a little bit upon that in terms of how you guys are thinking about managing the portfolio? Whether you'd be looking to potentially sell some assets or just sort of not reinvest pay-downs? Or how we should think about that over the near term?
Well, I mean, we would think it could be, as you would expect, Trevor, it could be a combination of both. There's a natural runoff character to the portfolio that you fully understand, that's one element. The other element is to the extent that the TBA spreads sort of have normalized maybe, retreated to a bit more normalized specialness, with exception, maybe, right at the moment of the 4.5, which are fairly special. Then that's another area where - that's an area that's subject to considering sort of pulling that back a little bit. So there could be some adjustments in portfolio size. But as we've seen in the past, it would be - over the course of the back half of last year, there was some amount delevering from runoff and other elements that rolled into that. So we consider both of those options.
Okay. That helps. And in terms of prepayment speeds, I guess, there's sort of two factors heading into the second quarter. One is there is usually a seasonal pickup, but we're also in a period now where rates have increased during the course of the first quarter also. So can you share your outlook on what you expect on prepayments going throughout the second quarter?
Well, seasonally, one would expect them to be higher. And we may have seen the beginning of that a little bit in April. So it wouldn't surprise us to see them higher in the second quarter and maybe higher in the third quarter and then lower in the fourth quarter. That's the pattern that they would have followed the last several years, I think, and that would be a sort of normal pattern. I think if that extent that rates hold in this neighborhood are higher, then we wouldn't necessarily expect them to spike. But we probably would expect to see them higher through the course of the summer, to some degree.
Our next question will come from Christopher Nolan of Ladenburg Thalmann .
The dividend, how much of that was a return of capital, if any?
For 2017?
I was thinking for the first quarter.
It's determined on an annual basis, at the end of the year, for tax purposes, Chris, so we don't know what it'll be for the year until the end of year comes out and you know what the components of your taxable income is between ordinary and capital. So I can't predict it, where it is going to be for right now.
Got you. And then on the DTL, is the intention there to hold onto it or to pay out in cash, tax liability in cash?
What's the question?
For tax liability.
Well, okay. So let me take that just for a second, Chris. So there's a bit of an accounting quirk here, which we sought to explain a little bit through the remarks, but in short form, the - we're required to set up a deferred tax liability for the amount of gain that will be realized over the life of those swaps, and that is how it would be realized if it came to fruition. It would be realized, the gain, and therefore the tax liability would be realized over the life of those swaps as they expire over time. Now on the other hand, what's not recorded on the balance sheet is the higher future funding costs that would expected to - would be expected to occur if, in fact, though - if, in fact, rates follow the forward curve, which is what gives rise to that gain in the swap position in the first place. So that's why we said in the remarks that over time those two would be reasonably expected to roughly offset each other and such that there would, in the end, be likely no actual tax liability. It just appears on the balance sheet because one doesn't record the higher expected repo funding costs that would occur in the future alongside the realization of the game.
Got it. On that note, Rock, if you guys were a tax pass-through entity, won't you get that benefit from the swaps without the DTL?
If we were a REIT, you wouldn't have a deferred tax asset liability reported on the balance sheet. So REITs, in general, they're required to record the deferred tax assets and liabilities. They could have either one of them depending upon the current construct of their portfolio and where rates moved from when they put the portfolio on. So again, REITs have deferred tax assets and liabilities, but it's not required to put them on.
On the balance sheet.
On the balance sheet, yes, but they exist. So maybe help us to understand, what was your question specifically again, Chris?
Well, I guess the core of my question is, is you guys took a $31 million provision - tax provision in 2017, you took an $18 million one in the first quarter here. And I'm just trying to understand what is the benefits of being a C corp as opposed to a pass-through entity for Arlington at this point?
Today, running through the income statement is all deferred noncash tax provision so we're not paying any taxes, historically, as a C corp as long as we have an NOL and NCL carryforward, and we won't as long as we continue to utilize our actual NOL and NCL carryforwards. We're not paying any income taxes. What you're really just seeing is accounting for potential future ones, but they're not - as Rock pointed out, the deferred tax liability that's on the balance sheet really wouldn't materialize if the forward curve is realized based on what's in that gain from the hedge because you'd have future higher funding costs that would offset it. So it's sort of a one-sided entry, if you will, on accounting. It sounds very odd to say that, but you're only pulling forward just the future benefit of the swap, you're not pulling forward the future costs, if you will, the future of higher funding costs. So it's not like we're really going to have a future tax liability.
So Chris, let me take it in a different way. If we were REIT, this would not show up on the balance sheet. We wouldn't be talking about this, number one. Number two, we're not paying cash taxes. Our tax benefits, our NOLs, pay our cash taxes for us. So we don't actually pay cash taxes presently until those NOLs are used up, and then at that point, presumably, we would convert to a REIT and then not pay taxes under a REIT structure. So just so we're clear, we're not paying cash taxes now on our income, a, and b, as it relates to this deferred tax liability, in the normal course of time, all those things being equal, we would not expect to pay actual cash taxes against that liability because the funding expense would offset that gain over time, roughly. We don't expect to pay cash taxes there either. And either way, as a REIT, in the future at some point, presumably, none of this would show up. All REITs have these moving parts. They all have assets. They all have differing movements in tax assets and tax liabilities, but they don't show up on the balance sheet.
I hear you, Rock. I hear you. You're not likely to pay the tax cashes, I hear you. And I hear that it's a one-sided accounting entry in terms of, you have to mark the liability but you're not getting - you're not able to mark the future cost of funds benefit that you're going to get, I hear you.
You got it.
My point is, though, is all these tax provisions are impacting book value per share, which is a key metric in terms which stock is valued. And so while no cash is being paid out and while the accounting entry doesn't fully capture the benefits of this, book value per share is still taking a hit.
I think, Chris, again, bottom line is that we're not paying any income taxes. We're passing off all of our earnings off to our shareholders in a tax-adjusted - tax-effected higher dividends because the tax rate on a dividend from a C corp is - the tax rate is significantly lower to the end of shareholder, so the shareholder is benefiting. So there's - everything benefit to us today. So the cosmetic appearance on the balance sheet of this issue, I mean, hopefully, we're explaining and that shareholders would really kind of look through it and see what really the true tangible book value is and just kind of ignore this accounting deferred tax liability that we don't really think is a true liability.
From an economic perspective, Chris, the deferred tax liability has no impact on the investable capital of the company. What drives the economic - the creation of economic return for the company is the existence and the allocation and application of the investable capital. The deferred tax lability has no impact on that.
That does impact book value. I appreciate you guys like tangible book value, but in my view, for this type of company, book value is still key metric.
[Operator Instructions]. Our next question will come from Dave Walrod from JonesTrading.
Can you talk just in general about repo availability and the competition for repo?
Interesting question. So turning back a little bit to what I said earlier, Dave, the structural shifts that have occurred in the repo market, from our perspective, from what we see in the actions that we see our providers taking, have created the most - probably the most robust circumstance we've seen in repo - in the repo market since the crisis. What we have seen is ongoing new participants seeking to add repo with us, increases in capacity and the desire for additional repo with us as time has gone on. Now that isn't to say that there are parties who have stepped back. We've talked about it in prior quarters and years, that there are some parties, particularly in - from the European set that have sort of pulled back from the market, but that's been offset by domestic firms as well as international firms from Asia and elsewhere over time. So we actually see the repo capability being as robust as it's ever been, if not more so. And we suspect it must be driven by some of the structural changes that occurred from a money market perspective and other structural beneficial steps that have occurred in the agency repo market - agency and government-related collateral markets.
At this time, I am showing no further questions in the queue. I now like to turn it back over to Mr. Tonkel for closing remarks.
Thank you, everyone, for your time and interest. And we will be available for further questions if you like to talk offline. Thanks very much.
Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.