Arlington Asset Investment Corp (AAIC) Q2 2021 Earnings Call Transcript

Image source: The Motley Fool.

Arlington Asset Investment Corp (AAIC)
Q2 2021 Earnings Call
Aug 6, 2021, 9:00 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. Id like to welcome everyone to the Arlington Asset Second Quarter 2021 Earnings Call. [Operator Instructions] Id now like to turn the conference over to Richard Konzmann. Sir, please go ahead.

Richard Konzmann -- Executive Vice President, Treasurer & Chief Financial Officer

Thank you very much, and good morning. Rich Konzmann, Chief Financial Officer of Arlington Asset. Before we begin this mornings 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 managements 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 companys 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 statements. I would now like to turn the call over to Rock Tonkel for his remarks.

J. Rock Tonkel -- President, Chief Executive Officer & Director

Thank you, Rich. Good morning, and welcome to the Second Quarter 2021 Earnings Call for Arlington Asset. Also joining me on the call today is John Murray, our Portfolio manager. During the second quarter, the Federal reserve struck a more Hawkish tone at its June meeting, leading to market concerns that it may begin to taper its bond purchases and raise interest rates sooner than previously expected, which rallied the 10-year U.S. treasury rate, almost 30 basis points and both flatten the yield curve. Against this backdrop, agency mortgage spreads widened and swap spreads tightened during the second quarter. In an improving economy, residential mortgage credit spreads tightened and home price appreciation continued its strong annual growth during the second quarter, supported by favorable supply demand dynamics. The companys long-term strategy is to construct an investment portfolio with multiple sources of income, which complement our historical agency MBS portfolio, diversify risk and improve the level and reliability of returns. Over time, the company expects to complement its allocation of capital and agency mortgages by redeploying capital into its other targeted segments, including mortgage servicing rights, mortgage credit and other asset classes.

We expect to maintain a strong, stable and liquid financial position by keeping leverage low and financial flexibility high while utilizing term financing structures where available. In addition, the company is focused on creating proprietary partnerships or platforms where possible to promote the predictability of cash flows, growth and the potential for compounding value creation opportunities layer on top of the current investment returns embedded in the companys investments. During the second quarter, the company made solid progress toward these goals by reallocating capital into both its MSR and mortgage credit strategies. As of June 30, the companys investable capital was allocated 39% to agency mortgages, 25% to mortgage servicing rights and 36% to mortgage credit. As discussed on our prior earnings call, the company has a strategic relationship with a licensed GSE approved servicer that enables the company to garner the economic return of an investment in mortgage servicing rights without holding the requisite license directly. Under the terms of our partnership, the company provides capital to our partner to purchase MSRs directly.

And the company, in turn, receives all the economics of the MSRs, less a fee payable to our partner. At our option and direction, our partner has the capacity to add leverage to increase potential returns to us, although the company has not utilized any leverage through its committed facility on its MSR investment portfolio to date. We believe this efficient, cost-effective and lower risk channel for investing in the economics of mortgage servicing rights differentiates Arlington. Our MSR investment portfolio has produced strong returns year-to-date through June 30, despite the significant fall in long-term interest rates and valuation multiples on mortgage servicing rights have been resilient, declining only slightly during the second quarter. During the quarter, the company made $39 million of new related MSR related investments, growing its MSR investment portfolio to $75 million or 25% of our investable capital as of quarter end. Subsequent to June 30, we have invested an additional $14 million in MSR related assets. Newly created mortgage servicing rights of Fannie Mae and Freddie Mac loans currently offer attractive return opportunities and provide a strong complement to agency MBS investment characteristics at current purchase price multiples of approximately 4 times or current coupon MSRS.

Unlevered MSR investments offer base returns in the high single digits. Furthermore, MSRs generally increase in value as interest rates rise, agency durations extend and/or mortgage spreads widen. Turning to levered agency MBS. Returns continue to benefit from low repo funding costs and ongoing federal reserve support. Against this backdrop, we are currently seeing available returns in the high single digits on levered agency MBS with an appropriate hedge position. However, a reduction in support from the Federal Reserve could lead to further widening of agency mortgage spreads, and the company continues to believe there is meaningful basis risk in agency MBS relative to the current spread return opportunity today, and therefore, remains cautious about significantly increasing the leverage and capital allocation to its agency mortgage investment strategy. Taken together, incorporating a levered agency MBS investment with MSR investment combines investments with complementary characteristics, decreases overall risk while increasing ROE. mortgage servicing rights tend to increase in value as mortgage rates rise and more specifically, when durations on agency MBS extend. This increase in value resulting from mortgage extension typically occurs when mismatches between levered agency MBS and hedges are highest.

Furthermore, MSRs offered attractive stand-alone return in the high single digits and by reducing the need for swaps as a hedge for agency MBS and their associated costs. MSRs provide a positive carry hedge for levered agency securities, replacing negative carry swaps with positive carry MSRs turns the largest drag unlevered agency MBS returns into a carry positive. Going forward, we would expect to replace components of our interest rate swap position on our agency MBS investment portfolio with MSRs as the company scales its MSR investments, thereby increasing combined returns by several hundred basis points into the low double digits while improving the protection to the companys capital. The underlying credit performance of the companys mortgage credit investments produced solid results during the second quarter, supported by strong economic environment. Subsequent to quarter end, the company received full repayment of its largest mortgage credit investment, one that was originated prior to the onset of the pandemic and delivered leverage returns of approximately 13%. The during the second quarter, the company made $58 million of new mortgage credit investments and continues to evaluate new opportunities that offer high risk-adjusted returns, particularly potential opportunities in residential business purpose loans.

Turning to the actual results for the quarter. The company reported book value of $5.94 per share as of June 30, a decline of 2.9% from the prior quarter end. The company continued to operate with low overall leverage and significant financial flexibility with an overall at-risk leverage ratio of 2.2 to one as of June 30. For the second quarter, the company reported a GAAP net loss of $0.24 per share and growth in operating income, core operating income of $0.04 per share from the prior quarter to a total of $0.07 per share. During the second quarter, the company returned capital to shareholders through accretive stock repurchases by repurchasing 2.6% of its outstanding common stock that accreted $0.05 per share to book value. Since June 30, the company repurchased an additional 1.1% of its outstanding common stock that accreted an additional $0.02 per share to book value. The company has a large remaining authorization from its board to repurchase shares of its common stock, and will look to continue to return capital to shareholders by opportunistically repurchasing shares of its common stock at accretive prices. Company did not declare a dividend on its common stock for the second quarter. The Board of Directors will continue to evaluate the payment of quarterly dividends on the common stock-based on multiple factors, including current earnings results, overall market conditions, liquidity needs, available returns on new investments, opportunities to return capital to shareholders through accretive stock repurchases and REIT distribution requirements.

In July, the company successfully completed a public offering of $37.8 million of five-year unsecured 6% senior notes using the proceeds to redeem its 6.625% senior notes due in 2023 with an outstanding balance of $23.8 million. The issuance allowed the company to both extend the maturity date and lower the interest rate of its debt while also raising additional investable capital at an attractive cost. Company has spent considerable time evaluating investment opportunities in single-family rental that offer potential attractive long-term returns supported by favorable supply demand dynamics, a healthy U.S. home financing market, an increasingly flexible term financing structures for institutional level single-family residential investments. We expect this favorable dynamic in U.S. single-family rental homes to continue for some time as we believe the limited supply of new homes will likely not meet the growing demand of housing based on expected demographic trends. The company hopes to make significant progress toward adding this segment to our capital allocation channels and potentially investing in its asset class in the coming quarter.

Overall, the company is very encouraged by the solid progress it has made to date in the transition for its long-term goals and is optimistic about its prospects going forward. The company has taken positive steps toward its objective of complementing our core agency MBS portfolio with high return, non-commodity quality investment channels, which provides diversification of risk, multiple income sources to raise overall returns to shareholders and offer sustainable ongoing investment flow. During the second quarter, the scaling of our MSR channel provided improved protection to the portfolio from agency MBS rate and spread volatility and raised profitability appreciably. As the company continues to expand its diversified investment strategies, we expect higher returns from these investments to provide increased earnings power over time, which can form the potential pathway for returning additional capital to shareholders.

As that deployment process occurs, we expect to maintain a strong financial position, highlighted by low leverage, high flexibility and the use of term financing structures where possible, enabling the company to be opportunistic and capture attractive investment opportunities that may arise across sectors as conditions evolve, and very importantly, to sustain the ongoing ability to utilize its stock repurchase authority and deliver attractive returns to shareholders over time. Thank you very much. Operator, I would like to now open the call for questions.

Questions and Answers

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question comes from Trevor Cranston with JMP Securities.

Trevor Cranston -- JMP Securities -- Analyst

Hey.

J. Rock Tonkel -- President, Chief Executive Officer & Director

Good morning Trevor.

Trevor Cranston -- JMP Securities -- Analyst

I guess, first question, a little bit bigger picture. With the progress you guys have made, building up the portfolio, improving the core earnings. Can you share your thoughts on how youre thinking about potentially reinstating a dividend? I guess, I mean, Im aware you guys have also been buying back shares. But just curious to get your thoughts on how youre thinking about the prospects of paying a dividend? Thanks.

J. Rock Tonkel -- President, Chief Executive Officer & Director

Yes. Sure. So we are encouraged. By the ramp in earnings and capital deployment thats providing that ramp in earnings. We have made meaningful progress, not only in the MSR side, but were hopeful that we have additional opportunities to discuss, as I referred to in the script here over the course of the coming quarter. And I think that leaves us with a positive picture and expectation over the course of the rest of the year. And I think that -- and thats something well be talking more about over the course of the remainder of the year. So I think the basis, the improved basis in earnings and capital allocation, combined with the additional partnerships that we hope to have in place here over the not-too-distant term. Certainly in the coming quarter will provide us with additional ramp to deployment in earnings and set the basis for further conversation about that over the course of the rest of the year.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Got it. Thats helpful and then a couple of questions on the MSR assets. I guess, first, I was curious what you guys thoughts are on the continued rally in rates, which has happened in July and what the risk is of a significant pickup in prepay speeds on the MSR assets, particularly if we were to get 30-year mortgage rates to drift back down meaningfully below that 2.94% note rate on the MSRS.

J. Rock Tonkel -- President, Chief Executive Officer & Director

Yes. I think, Trevor, certainly, thats something we think about daily. And were adjusting our -- our combination of agencies and our agency durations against that possibility every day. We would expect positive performance up rate from the MSR portfolio, both in terms of value and in terms of cash flows, and we would expect the agency duration from a lower coupon portfolio emphasis on the agency side to provide the down rate support in value. And what weve seen is that a couple of things. One, the primary rate has been a bit more resilient to the -- and remained and not fallen as much as the underlying rate curve we also have had a reasonable, if not more than reasonable recapture experience, and we expect that to improve over time, given the tenure of this relationship as it expands and as it goes on in time, we expect that recapture capability to improve. And we really need for the prime rate. One would need for the prime rate to really translate back to the low 2s to create a significant change in the income and value characteristics of that MSR book. Thus far, as you, Im sure, know, MSRs have remained fairly resilient, both in terms of their cash flows and in terms of their multiples to the rate fall, and thats partly explained by the fact that the primary rate has been a bit more resilient and has not fallen in lockstep with the rate curve.

Trevor Cranston -- JMP Securities -- Analyst

Yes. Okay. That makes sense. And I guess last thing, do you guys have a book value update you can give on the quarter-to-date performance?

J. Rock Tonkel -- President, Chief Executive Officer & Director

Yes. Id say were about flat.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Perfect. Thank you guys.

Operator

Thank you. Our next question comes from Jason Stewart with JonesTrading.

Jason Stewart -- JonesTrading -- Analyst

Hey. Thanks for the taking the question and good morning. Rock, I wanted to go back to the stock repurchase. I mean, obviously, with the stock where it is, its super accretive to book value, but theres got to be some limitation in your mind in terms of how much capital you can return via stock repurchases. Any update you can give us there?

J. Rock Tonkel -- President, Chief Executive Officer & Director

Well, what I can say, Jason, is what you probably expect. One, the level and amount of buyback that were conducting is directly related naturally to the combination of other investment alternatives and the scale of the organization overall. I would say -- you also, Im sure, know that we have a very significant sized buyback authorization in place. So we have great flexibility in that regard. And so I think you should expect to see us continue to be vigilant in repurchasing the stock, whether that means that its more at a faster pace and larger amounts or a slower pace and lesser amounts than we have been is completely dependent on those variables, the price level, the stock, the alternative investments and the overall scale of the organization, having added a little bit of additional capital to the investable capital of the firm over the course of the last quarter. Obviously, that gives us more flexibility. So its a core mainstay of our investment strategy and intent. And the magnitude will -- changes in the magnitude will depend on the variables I talked about. But we view it as undervalued and very appealing, both corporately and personally.

Jason Stewart -- JonesTrading -- Analyst

Yes, I would agree. A question about...

J. Rock Tonkel -- President, Chief Executive Officer & Director

I would also say that as the ramp in earnings is occurring, it gives us more flexibility on the buyback side.

Jason Stewart -- JonesTrading -- Analyst

Right. And we would hope that would perhaps change the valuation as well. One question on the SFR portfolio. I understand sort of the initial allocation to the loan side. But as youre thinking forward, are you looking at this sector as more an owner-operator or still as a lender?

J. Rock Tonkel -- President, Chief Executive Officer & Director

Well, we have a modest position as the lender in this through our business purpose loan investments that have been very attractive, and were very encouraged by, and we are on the lookout for new opportunities in that space every day in business purpose loans, including SFR loans. And were also hopeful about a possible opportunity to expand that capability over the next -- over the coming months. But specifically as to your question about single family rentals, we would conduct this as we have on the MSR side through a partnership with a highly credible owner operator, and we would be partnered with them in owning and operating a portfolio of single-family rental homes and taking advantage of that by financing it through term structures, term and nonterm, but term structures ideally, ultimately, available to institutional level investors in that asset class that have become increasingly compelling from a financing cost and advanced and term structure perspective.

So the combination of the supply demand dynamic, the funding dynamic at the home level in the housing market in the United States, and specifically, from a funding capability for institutional level investors in that space. The combination of all those things produces, we think, an attractive return profile, not just from the carry, the net carry of the rent stream versus the funding cost, but also including the potential for additional appreciation from here, obviously, we would not expect appreciation levels to continue at their recent historical levels. But we would -- but we are positive and constructive on the overall supply demand and price dynamic in the single-family rental space over time.

Jason Stewart -- JonesTrading -- Analyst

Okay. Got it. And one last question, and Ill jump out. A follow-up on Trevors on the MSR. I would assume that the acquisitions on the MSR, the additional $14 million doesnt materially change the note rate, but lets use $2.94. I mean, youd have to see primary rates to borrowers to be $2.40 something before youre meaningfully in the money. Is it your expectation that, that happens? And if its not, and rates move back up materially, where do you think this multiple based on your analysis could go from four times to what?

J. Rock Tonkel -- President, Chief Executive Officer & Director

Well, a couple of things there. As I said before, an agreement with you that wed have to see -- we think wed have to see prime rates in the lower 2s in order to really create a substantial surge in that prepayment and a reduction in the cash flow features. So thats not our expectation, but we are hedged for it. So were hedging every day to that dynamic as a possibility. Thats one of the compelling flexibility elements that the combination of the MSR with the agency portfolio provides. Is it perfect? No, it cant be perfect in every circumstance. But we are hedging for exactly that dynamic against the MSR book, knowing that as rates go up, that theres a substantial opportunity for both the improvement in the cash flows as prepayment rates decline, but also the expansion in the multiple. Now historically, we would have seen pre-pandemic multiples well above current levels. Were not expecting that into a higher rate move, but the combination of a multiple expansion from right now, maybe in the four range, right around 4%. So something more like 4.25% or so, plus the change in the cash flows we expect would provide for a substantial surge in value in an uprate move in that MSR portfolio and provide really attractive current returns, but also protection against the agency portfolio that is growing off its own set of returns and hedging the down rate protection -- down rate scenario against the MSRS.

Jason Stewart -- JonesTrading -- Analyst

Got it. Thanks for taking the questions. I appreciate it.

Operator

Thank you. [Operator Instructions] Our next question comes from Christopher Nolan with Ladenburg Thalmann.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Rock, do you anticipate increasing the capital allocation MSRs in the third quarter?

J. Rock Tonkel -- President, Chief Executive Officer & Director

Well, weve already -- as we said in the script, Chris, we already have allocated additional $14 million to that portfolio in the third quarter. And I think theres room for that to migrate up to some degree, additionally. I think that will depend on where we see relative -- where we see multiples and relative returns in that. We continue to see flow, some of -- some of which we think is attractive. And so we continue to bid tranches of that, both through the flow agreements that we have in place as well as limited bulk opportunities. I think -- so I think we would expect that, that probably would grow some during the third quarter, additionally. And keep in mind, we do have a committed facility available to us. We havent used it yet, but we do have that flexibility. So Im not sure we would see the capital allocation increase that much, but we may begin to apply some leverage as we further deploy the rest of the balance sheet. And I think that would have the consequence of improving returns on the MSR portfolio into the lower double digits from the high single digits.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

And then is there any type of mortgages -- excuse me, for the MSR book, is there any type of mortgages that youre targeting to be the receiver of the economics?

J. Rock Tonkel -- President, Chief Executive Officer & Director

Well, were looking -- what were evaluating typically is a current coupon mortgage thats been originated at reasonably proximate to the current rates. So at a given point in time, were investing in a right underlying pool of mortgages that were originated in recent history at something around the then current coupon. Today, that current coupon is going to be in the high 2s, and were going to -- and it would cost about four times to buy it -- youd buy it. And that circumstance to what would model to about an eight, give or take, eight unlevered return, but our experience has actually been that the model to 8s have turned in to be more like 9s and above. So thats been our actual experience is that the actual receipt of cash flows have exceeded our expectations. It generally, generically, this origination that were investing in is going to look like bank or savings and loan originated paper generically. And its all Fannie -- and its all basically Fannie Mae back.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Thank you.

Operator

Thank you. Your next question comes from Doug Harter with Credit Suisse.

Doug Harter -- Credit Suisse -- Analyst

Thanks. Rock, can you just talk about -- given the way youre structuring some of these investments for the MSRs or if you look at single families as partnerships, how much does scale matter? And just how do you think about the benefits of diversity versus kind of not being able to deploy that much capital into any one investment opportunity?

J. Rock Tonkel -- President, Chief Executive Officer & Director

Well, I think thats one of the compelling elements of the approach that were taking, Doug, is that were able to access the scale of a very significant organizations to -- and do that without the infrastructure intensity that one would have to undertake to do that directly. So in essence, thats a form of leverage, meaning its operational leverage, right? So were benefiting from operational leverage and benefit from their scale. Weve seen the benefit of that now in MSRs and to the extent that we proceed down the SFR path, we expect to see the same benefit. So what that means is that it allows us to invest and provide a level of diversification between complementary investment opportunities that provide together an attractive combination of returns.

Can each be financed to the extent that, thats necessary to support returns, can each be financed in favorable financing structures from a cost and term perspective, and work together to offset risks in each of the others. So thats the goal. So far, the MSR opportunity is playing out that way. Its early days, but its playing out that way. The expectation would be that we can leverage scale of a highly credible partner in the single-family rental opportunity as well. And to the extent we can do that, we can enjoy the same benefit of an attractive return stream without the infrastructure intensity. So we think it actually aids diversity and returns and allows us as a smaller company to participate with positive and powerful economics in spaces that we wouldnt otherwise at our scale, but can do so through these arrangements.

Doug Harter -- Credit Suisse -- Analyst

Helpful. Thank you Rock.

Operator

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

J. Rock Tonkel -- President, Chief Executive Officer & Director

Okay. Well, thank you very much. And if there are further thoughts or questions, please feel free to call. Thank you very much. Thank you for your time.

Operator

[Operators Closing Remarks]

Duration: 34 minutes

Call participants:

Richard Konzmann -- Executive Vice President, Treasurer & Chief Financial Officer

J. Rock Tonkel -- President, Chief Executive Officer & Director

Trevor Cranston -- JMP Securities -- Analyst

Jason Stewart -- JonesTrading -- Analyst

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Doug Harter -- Credit Suisse -- Analyst

More AAIC analysis

All earnings call transcripts