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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
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 Fourth Quarter and Full Year 2018 Earnings Call. [Operator Instructions].
I would like to now turn the conference over to Mr. Richard 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 would 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 and 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 Fourth 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.
Fourth quarter market conditions were challenging, particularly late in the quarter, characterized by a strong risk off sentiment; heightened volatility, a nearly 40 basis point rally in the 10-year U.S. Treasury rate; and significant widening of spreads across fixed-income products, including agency MBS; which reduced book values appreciably for companies like Arlington.
However, 2019 has gotten off to a strong positive start with a favorable investment environment for agency MBS, marked by meaningfully lower volatility and capital accretion as well as healthy speed -- excuse me, spread and earnings opportunities. Strong funding conditions and muted prepayment speeds continue to prevail.
In this environment, Arlington experienced a 6% recovery in book value during January to $9.22 per share, while also beginning the year with reduced risk of book value volatility and enhanced resiliency in this investment portfolio, driven by lower leverage at year-end.
Since the end of January, conditions for agency MBS have continued to be favorable. In the fourth quarter, the Treasury rate curve flattened as the spread between two year and 10-year U.S. Treasury rate narrowed 4 basis points to 20 basis points. Additionally, the Federal Reserve raised the target federal funds rate by 25 basis points in December. As markets decline in the wake of these and other events, the Federal Reserve struck a considerably more dovish tone at its January meeting as it signaled to markets that it would be prepared to adjust its balance sheet normalization policy while also not committing to further increases to the federal funds rate in the near term. Today, market participants no longer expect additional increases to the federal funds rate in 2019, a positive for investors and agency MBS, like Arlington.
Turning to our actual results for the quarter. We reported a GAAP net loss of $0.87 per share, which includes $1.11 per share deferred tax benefit, resulting in a pretax loss of $1.98 per share. Non-GAAP core operating income was $0.44 per share for the quarter, which was in excess of our quarterly dividend of $0.375 per common share. Core operating income compared to the prior quarter was impacted primarily by higher repo funding and swap rates, lower leverage, offset by higher agency MBS yields and lower G&A expenses.
During the third quarter, the company was well positioned against rising long-term interest rates with the company's agency investment portfolio comprised of a significant proportion of higher coupon securities along with an ongoing substantial long-duration interest rate hedge position. During the fourth quarter, the combination of the abrupt fall in long-term rates and the substantial widening of agency MBS spreads, relative to benchmark interest rates, led to losses on the company's interest rate hedges, markedly exceeding the gains on its agency MBS investments.
However, since December 31, volatility has subsided significantly, leading to agency spreads retracing a solid proportion of their moves from the fourth quarter. And as a consequence, the company's book value recovered 6% from year-end to $9.22 per share as of January 31. During the fourth quarter, the company reduced its recourse leverage and overall book value sensitivity. The company's total recourse leverage, measured as the company's repo financing and TBA commitments less cash to total investable capital, decreased nearly a turn from last quarter to end at 10.6% as of December 31.
As of year-end, the company's total agency MBS portfolio totaled $4 billion, consisting solely of specified agency MBS, a decline from $5.2 billion as of September 30. With the decline in the available TBA dollar roll advantage relative to specified agency MBS funded with repo throughout the quarter, the company closed its net long TBA position as of December 31. The resulting lower average leverage contributed to an approximate $0.03 per share decline in core operating income compared to the prior quarter.
Since year-end, the company has increased its investment portfolio to approximately $4.3 billion as of January 31. The weighted average CPR for our specified agency MBS during the fourth quarter was 8.25%, a significant decrease from 10.66% in the prior quarter and 9.55% in the fourth quarter of 2017. The weighted average effective asset yield on our agency MBS was 3.3% for the fourth quarter compared to 3.11% in the prior quarter. The 19 basis points improvement in the effective asset yield was driven by lower prepayment speeds and new purchases at higher current investment yield as a result of portfolio repositioning and reinvestment of monthly pay downs. The company's prepayment speeds declined further to start the new year within an average CPR for the first two months of the first quarter at 7.54%, which we expect would result in a weighted average effective asset yield of approximately 3.35% for that period.
The company's weighted average repo funding rate was 2.43% during the fourth quarter, a 26 basis point increase from the last quarter, consistent with the quarterly 25 basis point increase in the federal funds rate. Funding markets tightened in December, resulting in a weighted average repo funding rate of 2.72% as of December 31. But since year-end, repo rates have improved, with the company's average repo funding rate of 2.65% as of January 31, a 7 basis point improvement.
As of year-end, the notional amount of our interest rate swap was 84% of the outstanding repo funding balance. The note -- the total notional amount of all our interest rate hedges, consisting of interest rate swaps and U.S. Treasury futures, was 92% of our outstanding repo funding and TBA purchase commitments as of December 31, an increase from 86% in total last quarter-end. With the sharp decline in long-term interest rates during the quarter, the expected duration of our agency MBS investment portfolio declined nearly 1 year, resulting in the company's duration GAAP moving to a negative 1.1 years as of December 31 compared to a negative 0.2 years as of last quarter-end. Since year-end, that number has moderated back towards 0.
For the direction for the year, the company's general and administrative expenses were materially lower. Annual G&A expenses declined 28%, due primarily to lower annual short-term and long-term compensation expense, reflecting company performance as well as from reductions in noncompensation fixed expenses, more of which we believe are available to us in 2019. As we stated during last quarter's earnings call, the company has been evaluating possible long-term tax structures in light of our expectation that the company's NOL carryforwards would be fully utilized by mid-2019 as a C corporation. As a result of that evaluation, we announced at the end of December that our Board of Directors approved a plan for the company to elect to be taxed as a REIT, commencing in 2019. The company can still utilize its remaining $15 million in NOL carryforwards as well as its NCL carryforwards as a REIT to reduce its taxable income and distribution requirements that provides the company the flexibility to partially retain earnings as capital.
As a result of its expected REIT election, the company's deferred tax assets and liabilities were eliminated for GAAP financial reporting purposes as of year-end, which also leads to our tangible book value now equaling our GAAP book value. This simplifies our financial statements and results in a similar financial presentation to other REITs. As a REIT, the company's historical variable dividend policy will continue, and dividends will be evaluated quarterly by Arlington's board in conformity with REIT requirements. The company's lower leverage provides for reduced book value volatility and enhanced portfolio resiliency going forward. While that will have some moderating influence on earnings, several positive factors offer opportunities for improvement in long-term returns going forward.
First, the substantial widening of the agency MBS spreads during 2018 has increased the current returns available on purchases of new agency MBS. Second, the recent widening of agency MBS investment spreads has resulted in the basis spreads of a newly repurchase agency investment being better protected or less price-sensitive. Third, the recent dovish tone from the fed has reduced expectations of future rate hikes, which should benefit funding costs going forward. Fourth, repo funding availability for our agency MBS continues to be strong and funding spreads to LIBOR are currently attractive. Fifth, our G&A to capital -- current capital ratio was lower by approximately 150 basis points over the year, and we feel opportunities exist for some additional reductions in fixed expenses. In summary, the agency MBS spread widening that occurred during the fourth quarter has coincided with a shift to the overall economic and policy environment, setting the stage for compelling investment terms in the mid-teens on agency MBS today. This dynamic, combined with our shareholder-aligned internal management structure, makes us optimistic about future opportunities as we begin Arlington's next chapter as a REIT.
Operator, I'd like to now open the call for questions.
[Operator Instructions]. Our first question comes from Trevor Cranston with JMP Securities.
You mentioned the leverage number came down a little bit in the fourth quarter, and you also mentioned, I guess, that book value is, obviously, up somewhat since the end of the year, and you mentioned that you had added some MBS as well. Can you talk about, generally speaking, how you're thinking about the leverage number going forward compared to where you finished up the year at?
Thanks, Trevor. So as you know, Trevor, we've sounded the theme over time that folks shouldn't be surprised to see if over time we were gently reducing leverage, and I think the move in the fourth quarter is consistent with that. I think the -- we were mindful of the rising volatility during the fourth quarter, and so we thought it was opportune to take actions that were consistent with that longer-term theme. I think given the capital accretion in the first quarter and potentially some modest increase in the leverage from year-end, that sustains the balances today. And I would expect that the -- without stating a target or anything like that, that the overall trend that I've stated before, would continue, but specifically that leverage probably would remain in that range between where we were at year-end and where we were at the end of the third quarter. And I think that's supportive of our balances that are in the neighborhood of the balances on the books as of the end of January.
Got it, okay. And then you also made a comment when you were talking about the net duration position of the portfolio, that it moved back to approximately 0 since the end of the year. Is that solely through the MBS positions you added? Or can you maybe add some color on any other changes you might have made to the hedge book since the end of the year to get the duration back to 0?
What I said was that it had trended back toward 0. Meaning at the end of the year, it was negative 1.1, whereas at the end of the prior quarter, it had been, I think, negative 0.2. And I think it's trended back gently in the direction of where it had been. That's a combination of a variety of factors, but it's a combination of some fine-tuning in the portfolio, some modest fine-tuning in the hedge, nothing really significant, and price changes that have occurred in that intervening period of time, which have been favorable -- sorry, changes in the bonds.
Right. Yes, got it. And then last thing, you made a brief comment at the end about the expense ratio and having some potential to decrease your fixed expense base further this year. I was wondering if you could maybe elaborate on that comment a little bit. And how much room you think you have to drive that down this year?
Sure. I think it went sort of the following the way: noncompensation fixed expenses were down some in 2018, as we suggested in the script. And while those were not sort of monumental in size, every dollar transmits straight through to the shareholders. And in a generally reasonably strong economic environment, particularly late in the cycle, it's not necessarily common that one would find opportunities to reduce fixed expenses when there's unemployment at the ranges of that and other factors. But -- so every dollar that you can garner in that regard is a positive for your G&A to capital ratio and for transmission directly of those dollars to distributable income. So it's relevant. It's not a huge amount, but it's relevant. And we think that there is some incremental amount available next year in 2019 as well. And I think the amount maybe in 2018 was $0.5 million, maybe a little bit more than that, and I suspect there might be something of that magnitude or a little more than that potentially available to us in 2019. There's no guarantees, but every incremental amount of that contributes to distributable income for the shareholders.
Our next question comes from Christopher Nolan with Ladenburg Thalmann.
On the tax provision issue, given that the DTL is gone but you're not electing to become a REIT until year-end 2019, should we expect further income tax provisions for at least in the first half of 2019 or so?
Chris, this is Rich. No, we will not -- for financial statement purposes, we'll no longer have any income tax provisions in our income statement, no deferred tax assets or liabilities. So we effectively are acting as a REIT for the entire fiscal year 2019, starting in the first quarter. So no, you'll no longer see tax provisions or deferred tax assets or deferred tax liabilities in our financial statements.
Great. My follow-up would be on the CPRs declining. Is that just reflecting a change in the rate environment? Is it a change in the portfolio? Is it seasonal? Just trying to get a little color on that, please.
It's Rich, again. I'd say it's a combination of all those factors. There's certainly a seasonality component. Typically, the fourth quarter and the first quarter are usually your lowest quarters in terms of speeds, just because of seasonality of when people move and things of that nature, and there's also an element of just where rates are. They're still above the historical amounts we had several years ago, so a lot of people are priced out of ugly financing. And also it's a factor of this home price appreciation starting to moderate. People's homes aren't appreciating as fast they were a year or 2 or 3 ago. So again, reducing people's opportunities to refinance on their loans.
I'd say, in our case specifically, Chris, we also benefit from a pretty concentrated position in specified pools with prepayment restrictions that are pretty robust. So that has benefited us as well as the larger -- as well as the larger trend items that Rich alluded to.
Great. And just a housekeeping item. The cost basis of the portfolio -- agency portfolio increased quarter-over-quarter, that's just really allocating capital from the TBAs into balance sheet portfolio?
That's correct, Chris. So it's a -- our total portfolio was down, but most of that was in the TBA book. So if you're looking at just our specified agency MBS, the balances didn't change as much. But most of the change in our overall investment profile was in the reduction in our TBA book.
[Operator Instructions]. Our next question comes from Doug Harter of Crédit Suisse.
This is actually Joshua for Doug. Just given the fed hike -- fed rate hike expectations this year, what are you guys seeing from repo lenders, both in terms of demand for your repo? And also, can you talk about any opportunities to maybe lower funding costs throughout the rest of the year?
So a couple of thoughts. The trend over time continues where funding opportunities are readily available and, in fact, demand really exceeds our need. I suspect that may be true for others in the industry as well, probably is. Where demand exceeds our need for that funding, there are several counterparties today that we just don't have enough demand to meet their supply. Meaning -- so we've got underutilized funding books that are available to us going forward, and I think that's a signal about the robustness of the funding markets. Funding costs tightened up a little bit at year-end, as they often do, as markets were tight. And they've backed down, as I said in the script, by 6, 7, 8 basis points, something like that. The curve is pretty flat, right? So your swap rates today on new dollars invested really aren't that much different from your cash repo funding cost. So I'm not sure I'd speculate on where that all trends over the year, but it seems to us that the overall supply demand for repo is quite positive. Repo spreads to LIBOR are in line to favorable, and the overall policy and rate environment seems to be fairly benign, all of which are positive for Arlington and companies like it in this space in terms of return opportunities going forward at a time when mortgages have widened and create more spread opportunity than they did before. So I'd say all that is -- all that we see is generally favorable. And without making a prediction about what the fed will or won't do and what rates -- what rate increases may or may not happen, as it looks today, the environment is, again, benign and favorable.
There are no additional questions at this time.
Thank you very much. We appreciate your time and look forward to talking in the future. Thank you.
Thank you. Ladies and gentlemen, this concludes today's presentation. You may now disconnect.