C3.ai Inc

NYSE:AI

Earnings Call Transcript 2020-Q2

[Operator]

Good morning. I’d like to welcome everyone to the Arlington Asset Second Quarter 2020 Earnings Call. Please be aware each of your lines is in a listen-only mode. After the company’s remarks, we will open the floor for questions. [Operator Instructions]

I would now like to turn the conference over to Richard Konzmann. Mr. Konzmann, you may begin.

[Richard Konzmann, Chief Financial Officer]

Good morning, thank you very much. 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 in evaluating any forward-looking statements.

I would now like to turn the call over to Rock Tonkel for his remarks.

[Rock Tonkel, President and Chief Executive Officer]

Thank you, Rich. Good morning and welcome to the second quarter 2020 earnings call for Arlington Asset. Also joining me on the call today is Brian Bowers, our Chief Investment Officer.

Financial market conditions improved significantly during the second quarter, driven by unprecedented support by federal monetary and fiscal stimulus policies. Despite the uncertain path of an economic recovery, risk asset prices rallied during the quarter with equity markets recovering most of their losses from the prior quarter. Most fixed income asset classes also recouped some of their prior quarter losses as credit spreads generally tightened during the second quarter. And the Federal Reserve signaled its intention to keep short-term interest rates at their current level for the foreseeable future, leading to low interest rate volatility and a slight steepening of the yield curve during the quarter.

Agency mortgage performance was mixed for the second quarter. Elevated prepayment expectations adversely impacted higher coupon agency MBS, resulting in generic lower coupon bonds outperforming their higher coupon counterparts. Agency MBS backed by specified pools, like those Arlington owns, outperformed generic TBAs as pay-up premiums for specified pools increased significantly during the quarter. As a result of the Federal Reserve rate cuts and ongoing support for repo operations, repo funding for agency MBS remains readily available at lower funding costs.

While the current landscape for the levered agency MBS investing has improved from last quarter, certain investment risks have also increased, including the uncertain path of prepayments in a lower interest rate environment and higher pay-up premiums embedded in the current pricing of specified pools. With the improvement in the financial markets during the second quarter, values of most mortgage credit asset classes recovered some of their losses from the prior quarter, reflecting a general tightening of credit spreads.

However, there continues to remain lack of clarity in the timing and the degree of the reopening of the economy, and its resulting financial impact on both residential and commercial mortgage borrowers. Accordingly, there is uncertainty surrounding the timing and magnitude of any credit losses in mortgage credit assets. Despite the positive economic impact of federal monetary and fiscal policies on current market condition, the company continues to believe that the full financial ramifications from the varying degrees of shutdowns across the U.S. economy may not be appropriately priced in current investment spreads in certain fixed income assets.

As a result, the company has continued to maintain a relatively cautious stance, which prioritizes preservation and protection of the company’s balance sheet through low leverage and substantial liquidity. Accordingly, the company is continuing to take a selective approach to redeploying its capital or increasing leverage significantly in the current environment.

Turning to the actual results for the quarter. The company reported GAAP net income of $0.26 per share and non-GAAP core operating income of $0.01 per share. The company’s book value was $5.63 per share as of June 30, a 7% improvement from last quarter as both its agency MBS and mortgage credit investment strategies recovered some of their losses from last quarter. During the second quarter, the company also made accretive repurchases of its common stock, repurchasing 3% and of its outstanding common stock. The company continues to maintain a low leverage profile with its short-term secured financing to investable capital ratio at 1.2:1 as of June 30.

In order to maximize its liquidity, the company did not declare a dividend on its common stock during the second quarter. The company’s common stock dividend paid on February 3, combined with its tax loss carryforwards, provides the company with flexibility in managing its REIT distribution requirements this year. The company will evaluate future common and preferred stock dividends on a quarterly basis based upon multiple factors, including the overall economic and market conditions, return opportunities on investments, its ongoing liquidity needs and REIT distribution requirements.

The company was encouraged by the performance of both its agency MBS and mortgage credit portfolios during the second quarter as both positions benefited from spread tightening and attractive investments made during the quarter, while continuing to operate with overall low leverage and financial flexibility. During the second quarter, the company increased its capital allocation to mortgage credit assets by opportunistically investing in new investments at attractive risk-adjusted returns.

As of June 30, the company’s investable capital was allocated 62% to agency MBS and 38% to mortgage credit investments. Although lower repo funding costs have improved current return on equity opportunities in agency MBS, pricing has become relatively expensive due to the Federal Reserve support through its substantial purchases of agency MBS. Within its agency MBS investment portfolio, the company decreased its allocation to higher coupon securities during the second quarter as elevated prepayment speed expectations have significantly diminished the return opportunities in this end of the coupon stack.

In the agency mortgage market, the company currently sees greater return opportunities than lower coupon bonds with available levered returns in the high single digits. Notwithstanding the credit protection and liquidity associated with agency MBS, with available levered returns on a new dollar invested generally in the high single digits with appropriate leverage, we remain relatively cautious on levered agency MBS exposure. The composition of the company’s current credit – mortgage credit investments consists of a balanced portfolio of non-agency MBS collateralized primarily by residential – commercial mortgage loans, financing collateralized by mortgage servicing rights and a commercial mortgage loan, which is performing fully in line with initial expectations.

The company is actively evaluating investment opportunities across various asset classes, including mortgage-related investments, specialized collateralized investments and other potential platform investment opportunities as they develop in this evolving investment environment.

During the second quarter, the company observed attractive return opportunities in mortgage servicing rights and financing for MSRs as the values of mortgage servicing rights declined due to the elevated prepayment expectations and uncertainty surrounding servicers’ ability to meet servicing advances associated with anticipated borrower default and forbearances, which then led to spreads on the financing of MSR assets widening meaningfully. MSR financing investments typically consist of term senior notes securitized by mortgage servicing rights that also carry a corporate parent guarantee. The company took advantage of attractive risk-adjusted returns available in MSR financing opportunities with significant collateral protection by making several new investments in this asset class during the quarter.

As of June 30, the company held $64 million of MSR financing investments. And the company is continue to evaluate additional attractive investment opportunities related to mortgage servicing rights either through direct investments in MSRs or financings collateralized by MSRs. The company does not currently have significant repo funding exposure in its mortgage credit investment portfolio. As of June 30, the company did not have any outstanding repo funding on any of its non-agency MBS or MSR financing investments.

The company’s sole funding exposure on its mortgage credit investment portfolio consists of $32 million of repo funding for a commercial mortgage loan with strong credit statistics, with a repo funding maturity in May 2021 that has had no margin calls to date. While the dislocations in the financial markets from the COVID-19-induced economic shutdowns have laid the foundation for attractive investment opportunities in certain mortgage-related and other credit assets, the company believes certain credit assets may not yet have fully priced in the effects of the economic outlook.

We are executing on a plan of a selective approach that focuses on current investments, which provide acceptable returns on capital and will enable the company to deliver a positive economic return to shareholders over time, while retaining sufficient liquidity that will provide the company with ongoing ability to capture attractive investment opportunities that may arise across sectors as economic conditions evolve over the coming quarters.

In summary, the company’s high level of liquidity and low leverage ensures the company is well positioned to take advantage of attractive investment opportunities that may be created as the full economic impact of the current economic downturn materialize and should enable the company to deliver attractive risk-adjusted returns to shareholders over time.

We’d be happy to take questions, if you have them.

[Operator]

[Operator Instructions] We’ll take our first question from Doug Harter with Credit Suisse.

[Doug Harter, Credit Suisse]

Thanks. Rock, can you just talk about kind of how – obviously, you did buy back some stock during the second quarter, how you’re thinking about additional share repurchase? And how the attractiveness of share repurchase compares to the investment opportunities you just talked about?

[Rock Tonkel, President and Chief Executive Officer]

Sure. Morning, Doug. I guess I’d take two things. One, obviously, capital is a precious commodity and reducing scale by repurchasing securities on the balance sheet has to be something that we’re very deliberate about, given our scale. So we start with that part of the equation. Having said that, I’d say secondly that as we sit here today, I don’t think we’re really viewing the world much differently, the markets and our stock and our circumstances versus markets much differently than we were during the second quarter. So I’d say, generally, our orientation and our thought process would be reasonably in line with where it was while we were executing that process in the second quarter.

[Doug Harter, Credit Suisse]

Great. And can you just remind us how much authorization you have remaining on your – under for buybacks?

[Rock Tonkel, President and Chief Executive Officer]

So at the end of the quarter, I think there was probably, give or take, a million shares left. And we’ve undertaken a new authorization as well, which you’ll see disclosed, I think, later today or – later today.

[Doug Harter, Credit Suisse]

Okay. Thank you.

[Operator]

And we’ll take our next question from Trevor Cranston with JMP Securities.

[Trevor Cranston, JMP Securities]

Thanks. You guys talked about some of the reasons why you’re somewhat cautious on the agency space at the moment. But can you sort of add some color around how you way the fact that you think assets may be a little bit overpriced with the Fed in the market versus the cost of giving up the carry income associated with relevering that book? And maybe just talk a little bit about sort of what you would be looking for to see to start adding to that portfolio again? Thanks.

[Rock Tonkel, President and Chief Executive Officer]

Sure. Well, let’s see, I think – I don’t know that I would say our thoughts are terribly outlined with maybe some others. A couple of things. One, obviously, the government is heavily involved in the net supply equation, and that’s had a very powerful effect on stabilizing both sides of the agency equation, prices as well as funding. And I think on the one hand, if one was to contemplate whether you think that bid or that influence is likely to continue to be there for a while, I think we and others would probably conclude that it probably will be around for a while. I don’t think the government has probably indicated any – given any indication that it’s intends to pull that support any time soon.

Having said that, all of us who’ve been around this space know that if the government were to give any – even a slightest hint of pulling back, that could have a negative effect on pricing. The other factor here, as I think we’re all aware, is the uncertainty around speed. And so as we sit here today, let’s take the low end of the coupon stack, which we’d probably find appealing in a spec 2 at somewhere around 1.05%, but with a market expectation of maybe an 11% speed or something like that.

If it all goes according to plan, maybe you can generate a 1.25%-ish-type yield off of that, which seems like it’s not, though it’s reasonable. But we’ve also all observed that speeds, the path of speeds is – can be pretty uncertain here recently. And so it’s not outside of the room of possibility that, that could double. And if it doubles, then your yield is now probably closer to 1% or even potentially below, but it’s certainly down towards 1%. And with funding and hedging associated with that, you’re probably talking about cash funding that’s going to be in the high teens or 20s, something like that. If you’re – depending on where you are for us, it’s probably in the 20s. And then if you’re hedging half of that from a duration perspective, then you’re looking at something on a blended basis, which is going to be in the 30s. And I think that tells you that, that all adds up to an ROE that on an appropriately levered basis is going to be in the high single digits.

And from our perspective, as we look at other alternatives, we view that we are – we still believe we’re able to generate from a selective approach to alternatives to the agency, cash carry that’s going to be in the mid-single digits on an unlevered basis. And potential upside from discounts associated with that, which gets you ideally toward double digits, but not in every case, but would likewise get you into that high single-digit category or other non-agency assets that can deliver on an unlevered basis, carry double digits without really a discount.

So, you’re not likely to gain a lot of upside, but where you can generate carry on an unlevered basis that’s going to be at least touching, if not more than touching the double digits. And so as we balance the equation, we’re looking at agency high single digits with a significant amount of variability around speed expectations and therefore, net profitability from that asset and potential movements in capital related to that speed volatility, even as the government provides a stabilizing influence, a powerful, stabilizing influence across both sides of the key equation for agencies.

So, we balance that against the return profiles that I just illustrated in the non-agency side. And we also balance that against the securities on our own balance sheet. And I think the result is what you saw in the second quarter in which we essentially doubled the size of that alternative portfolio with those exact metrics in mind, mid-to-high single digits carry with some discount associated with it.

Now, those assets have become more expensive, which is why you saw the growth in book value and the economic return at the level that we did. So that equation is a little bit less favorable today than it was two months ago, three months ago. But it still stands, and that is the equation that we are thinking about all the time. And so agency has absolutely has a place, but the other two alternatives are also have a role to play in our portfolio allocation process as well. And sustaining a meaningful amount of liquidity and low leverage to take advantage of opportunities or dislocations as they arise is also a priority for us.

So that’s how we’re thinking about it. That’s what is the driver behind not relevering the agency portfolio, maybe up back to the levels that it historically had been or along that pathway. And I think in line with that, we view ourselves as on a very deliberate and deliberate approach of making selective asset investments in the types of asset profiles that I outlined that will occur over the coming two to three quarters or so and provide a ramp in allocation as well as a ramp in the earnings profile of the company to accompany that.

[Trevor Cranston, JMP Securities]

Okay, great. Thank you. And then just another question on the mortgage credit portfolio. The two new asset classes you added there, the bigger one being the MSR financing and then also some of the resi MBS, looks like both of those are carried pretty close to par value. Can you talk about what your expected unleveraged yield is on those new assets that you bought during the second quarter? Thanks.

[Rock Tonkel, President and Chief Executive Officer]

Well, they’re carried at fair value. And just so I’m clear on the question, Trevor. You’re asking about the, give or take, $75 million of incremental assets that were added from quarter-end to quarter-end. Is that what you’re describing?

[Trevor Cranston, JMP Securities]

Yes, exactly.

[Rock Tonkel, President and Chief Executive Officer]

And you’re asking what the cash carry is or the total expected return on those?

[Trevor Cranston, JMP Securities]

Well, both, I guess, the sort of the yield you’ll be amortizing and, I guess, what your expected total return might be?

[Rock Tonkel, President and Chief Executive Officer]

Well, it’s a blend, right? Some of them are straight coupon instruments, and those are going to be in the mid-to-high single digits, call it, 6%, 6.5%, maybe some a little higher than that. And then others are going to be a combination of current and upside. And those are going to be a little bit lower currents, maybe. But with the discounts, those are going to be high single digits and some in the teens – so I’m sorry, not teens, double digits. But I’d say the range for those that don’t have a discount upside would be 6.5%, 7% – 6%, 6.5%, 7%, something like that. And the – those assets that do carry discounts will be a little higher than that 7%, 8%, 9%.

[Trevor Cranston, JMP Securities]

Okay, great. And then the last question, just back on the agency book. It looks like you guys have a significantly smaller hedge portfolio relative to the agency book than you have historically. Can you talk about your approach to hedging right now and kind of where your interest rate sensitivity is at?

[Rock Tonkel, President and Chief Executive Officer]

Right now, we’re at 0.2 positive GAAP. And that’s with all the elements that I described before, it’s slightly positively durated. And most of that is in the long end. That hedge is mostly in the long end. And as you can see – you’ll see it if it’s not in the – if you didn’t see in the release, you’ll see it in the Q. It’s more of a 10-year focus.

[Trevor Cranston, JMP Securities]

Okay, got it. Thank you.

[Operator]

And we’ll take our next question from Jason Stewart with Jones Trading.

[Jason Stewart, Jones Trading]

Good morning, gentlemen. On the credit side of the investment book, what does current term financing look like? And how is that driving or impacting the opportunities that you evaluate?

[Rock Tonkel, President and Chief Executive Officer]

Well, I guess first, we’re not really putting financing on the credit side of the book, generally. There may be exceptions to that. But that portfolio is essentially unlevered, except for the one piece of repo on one – on the only commercial mortgage that we have. So, we’re not really focused on layering in a lot of repo financing, external financing, I should say, non-structural financing on the credit side of the portfolio. If we were, I think you’d be looking at financing rates that would be in the 300 basis point range, something like that, maybe 350 on some. And depending on where they are on the credit stack, if they’re really senior like a – take a really senior RPL bond, that’s going to be closer to 2%-ish. And those that are a little bit further down the stack might be 3%, 3.5%. Those are – that would be against assets that are going to carry mid- to high single digits carry. And if you’re going to lever them, you’d be levering them against a 3%, 3.5% cost of funds or something like that. But we’re not doing that. And I don’t think we anticipate doing that soon. We don’t have a need with this level of liquidity on the balance sheet.

[Jason Stewart, Jones Trading]

Got it. I guess I was just thinking more down the road, if you did apply leverage what the NIM would look like on it, and it sounds like it’s pretty attractive.

[Rock Tonkel, President and Chief Executive Officer]

As a broad matter, Jason, I think it’d be fair to say, if you assumed a 5% or 6% carry, something like that, it’s just an example against a 3%, 3.5% net cost, that probably would be a fair assumption. We’re not doing that today, but that could be possible down the road.

[Jason Stewart, Jones Trading]

Okay. Thank you, sir.

[Rock Tonkel, President and Chief Executive Officer]

Thank you.

[Operator]

We’ll take our next question from Christopher Nolan with Ladenburg Thalmann.

[Rock Tonkel, President and Chief Executive Officer]

Hey, Chris.

[Christopher Nolan, Ladenburg Thalmann]

Rock, can you clarify – hey, how are you doing? in your comments, and I appreciate the detailed comments you gave on the new strategy. But when you’re mentioning high single-digit return for RMBS, was that unlevered?

[Rock Tonkel, President and Chief Executive Officer]

You mean on the credit side, on the obviously non-agencies?

[Christopher Nolan, Ladenburg Thalmann]

Yes.

[Rock Tonkel, President and Chief Executive Officer]

Yes.

[Christopher Nolan, Ladenburg Thalmann]

Okay.

[Rock Tonkel, President and Chief Executive Officer]

Now, some of those assets, they may have some structural leverage on them. In some cases, but in many cases not. Those would be unlevered, raw, either carry or a combination of carry and discount realized as upside over time.

[Christopher Nolan, Ladenburg Thalmann]

Okay. And then I guess, I’m trying to get my hands around the strategy, given how the MBS market has evolved in the second quarter, given the decline in repo funding costs. And it seems to me just boiling it down, you’re making a bet that prepayments are going to materially increase so impacting RMBS and that the U.S. economy will recover, which will enable you to keep your credit losses manageable. Is that a reasonable way to look at this?

[Rock Tonkel, President and Chief Executive Officer]

Yes. I – possibly, meaning, prepay speeds are uncertain. And while one can fund these assets at attractive levels on a repo basis, they still have to be hedged. A 2% asset, 2% spec pool, which today would probably be the asset of choice, either a 2% or 2.5%, but let’s use the 2% for now, given where rates, markets, prices and yields are, that is an asset that’s going to require significant hedge. And so by placing a significant hedge on that, you’re raising the cost of funding and therefore, shrinking the net spread available on that asset. And so if you get that, combined with some potential elevation in expected speeds from the number I used before, which was an 11% to say a 15%, you will realize less spread than you may believe you bargain for upfront. And it could be quite significant. So, the returns there are just less predictable than maybe they appear on the surface and maybe than they have been at points where there’s been a bit wider spread opportunity.

Now, others have a different view on it. And obviously, they’re expressing a quite different view in their allocations. But we look at it that the combination of those uncertainties around those speeds and those net resulting spreads and the capital volatility that can occur from that, justifies an allocation that doesn’t require a great deal of leverage in the agency, and at the same time, provides the opportunity to capture comparable returns. And in some cases, maybe higher returns on an unlevered or very low leverage basis on the non-agency side with liquidity, albeit less than the agency side, but some liquidity as these are CUSIPs. Or by entering into opportunities that may not have a CUSIP, may not have the same liquidity, can offer double-digit returns, either in pure carry or in a combination of carry and discount upside.

So, those are sort of the three sets of types of alternatives that we’re looking at as well as platform opportunities that I identified in the script. But those are the opportunities that we focus on. And at the same time, we’re focusing on the balance sheet – securities on our own balance sheet as – and balancing each of those day by day.

[Christopher Nolan, Ladenburg Thalmann]

And also, just as a clarification, you might have mentioned it earlier. What are the – what type of assets are you buying at a discount and hoping to collect on some discount accretion?

[Rock Tonkel, President and Chief Executive Officer]

Well, they’re principally residential in character. They’re almost exclusively residential in character. But – so I mean they’re common residential assets. We’re not focused right now on the commercial side. Our commercial exposure is very small. And I gave commentary in the script on the one commercial loan that we have that’s performing very well and has a repo facility that extends out almost a year. So our focus is primarily residential and residential-related assets, either CUSIP or non-CUSIP. And then also, we’re focused on platform opportunities that we’ve identified and continue to evaluate in addition to agencies.

[Christopher Nolan, Ladenburg Thalmann]

Great. Thank you.

[Operator]

Mr. Tonkel, there are no more questions at this time.

[Rock Tonkel, President and Chief Executive Officer]

Thank you very much.

[Operator]

Thank you, ladies and gentlemen. This concludes today’s teleconference. You may now disconnect.