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Edited Transcript of CMO earnings conference call or presentation 24-Oct-19 1:00pm GMT

Q3 2019 Capstead Mortgage Corp Earnings Call

Dallas Oct 28, 2019 (Thomson StreetEvents) -- Edited Transcript of Capstead Mortgage Corp earnings conference call or presentation Thursday, October 24, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Lance J. Phillips

Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary

* Lindsey Crabbe

Capstead Mortgage Corporation - Manager, IR

* Phillip A. Reinsch

Capstead Mortgage Corporation - President, CEO & Director

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Conference Call Participants

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* Eric J. Hagen

Keefe, Bruyette, & Woods, Inc., Research Division - Analyst

* Steven Cole Delaney

JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research & Senior Research Analyst

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Presentation

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Operator [1]

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Good day and welcome to the Capstead Mortgage Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Lindsey Crabbe. Please go ahead.

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Lindsey Crabbe, Capstead Mortgage Corporation - Manager, IR [2]

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Good morning. Thank you for attending Capstead's third quarter earnings conference call. The third quarter earnings release was issued yesterday, October 23, 2019, and is posted on our website at www.capstead.com under the Investor Relations tab.

The link to this webcast is also in the Investor Relations section of our website. An archive of this webcast and a replay of this call will be available through January 29, 2020. Details for the replay are included in yesterday's release.

With me today are Phil Reinsch, President and Chief Executive Officer; Robert Spears, Executive Vice President and Chief Investment Officer; and Lance Phillips, Senior Vice President and Chief Financial Officer.

Before we get started, I want to remind you that some of today's comments could be considered forward-looking statements pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are based on certain assumptions and expectations of management.

For a detailed list of all the risk factors associated with our business, please refer to our filings with the SEC, which are available on our website. The information contained in this call is current only as of the date of this call, October 24, 2019. The company assumes no obligation to update any statements, including any forward-looking statements made during this call.

With that, I'll turn the call over to Phil.

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [3]

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Thank you, Lindsey. After a few brief remarks, Lance will give a recap of the quarter, and then we'll open the call up for questions.

With this quarter's core earnings per share of $0.11, we've now reported core earnings at or near our current $0.12 dividend run rate for each of the last 3 quarters.

This quarter, we absorbed higher mortgage prepayments due to both seasonality and the declines in longer-term interest rates experienced the last 2 quarters. We also weathered lower swap receive receipts due to declines in 3-month LIBOR relative to prevailing repo costs and dealt with the late September repo market funding stresses with little impact on our borrowing cost.

That said, repo rates have been stubbornly elevated relative to the Fed funds for some time now, representing a headwind for our financing spreads and earnings.

Further, lower prevailing rates and higher levels of market volatility have had a negative effect on portfolio and swap valuations, contributing to a 3.7% decline in book value this quarter and leading us to take a cautious approach to leverage levels in the deployment of $75 million in new common equity capital raised in early August.

Despite these market conditions, Fed fund cuts in July, mid-September and perhaps the end of this month will benefit us significantly and should contribute to stronger earnings in the quarters to come.

Additionally, we took advantage of lower prevailing interest rates earlier in the quarter to replace higher rate swaps in our hedging book with new lower rate swaps, all while not dramatically altering our overall hedge position and effectively locking in market expectations at the time of these trades for more Fed rate cuts.

As a result of these efforts, at September 30, the fixed rate on our swap book stood at 2.04%, down considerably from an average fixed rate of 2.14% during this quarter, which will lead to significantly lower hedging cost in the quarters to come.

I want to emphasize that while the mortgage prepayment levels we experienced this quarter were higher, the rate of increase at under 15% quarter-over-quarter was significantly less than the overall 40% increase in agency fixed rates speeds.

Further, ARM speeds actually declined for October versus continued increases in the fixed rate universe.

To wrap this up, we are increasingly optimistic about our earnings prospects, with mortgage prepayments moderating, short-term interest rates declining with no swap help from the Fed, hedging costs declining, attractive returns available on agency ARMs and dry powder, thanks to cautious leverage management and our timely equity raise.

With that, I'll turn the call over to Lance.

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary [4]

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Thank you, Phil. We reported GAAP net income of $3.2 million this quarter, a net loss of $0.02 per diluted common share.

Our core earnings were $14.8 million or $0.11 per diluted common share. The difference between our GAAP and core results this quarter primarily relates to the impact of lower prevailing interest rates on our interest rate swap agreements and other derivatives held for hedging purposes.

We included a reconciliation of these differences on Page 9 of our press release. Portfolio yields averaged 2.76% during the quarter, a decrease of 6 basis points from the 2.82% we reported in the second quarter.

Yields declined primarily due to the effects of higher mortgage prepayment levels while cash yields were largely unchanged.

Our portfolio-related borrowing cost, after adjusting for hedging activities, averaged 2.31% during the third quarter, 4 basis points lower than in the prior quarter.

The benefits of a larger decline in unhedged rates and a lower fixed rate -- lower fixed rates on our swap book were partially offset by the continued decline in 3-month LIBOR, which negatively impacted the receive leg of these derivatives.

Book value decreased $0.33 per share during the third quarter, ending at $8.60 per common share, reflecting a $0.23 decline associated with our hedging activities, $0.06 in initial dilution related to our capital issuance in August and $0.03 in partially related pricing change or portfolio-related pricing change.

With that, we will open the call up to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions). Our first question comes from Eric Hagen with KBW.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [2]

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At what point did you guys reduce leverage during the quarter? It looks like there was a fair amount of nominal spread widening, which would suggest that you might actually want that leverage to capture the return available to you in a relatively more attractive spread environment. I'm just trying to get a sense for the timing and kind of the nature of reducing leverage.

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary [3]

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Sure. I mean we made a conscious decision during the quarter to take our leverage down just given what was going on in the market at that point in time.

Obviously, we raised $75 million in capital. We didn't feel the need to completely deploy that at that point in time, prepayments were running high and there was disarray in the repo markets. So we just thought there might be some better entry points. And if you look at where we are now in the fourth quarter, spreads haven't snapped back. So we have some dry powder to deploy if we see some year-end selling.

Having said that, given where spreads are right now, we can deploy that in the 8.75 to 9 area and get returns. They're comparable to what we were getting at 9.5x leverage a few months ago, as you alluded to, because of the spread widening.

So we just think it's prudent at this point in time, given what's going on in the repo markets and prepays, to keep our leverage a little low.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [4]

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Okay. So the capital raise in July was not used directly for delevering. It was -- the delevering took place after -- separate to...

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary [5]

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No, we were -- we continue to buy bonds throughout the quarter, we just didn't buy as many as we could have because we made a conscious decision to take our leverage down, irrespective of the capital that we raise.

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [6]

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Yes. So a lot of the return of -- some of what we experienced in the second quarter with rates dropping and market volatility picking up and that helped inform our decision-making.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [7]

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Okay. That makes sense. I guess -- could you have also captured in a sense that the same goal of reducing risk on the balance sheet by buying back some of your preferred stock with the common that you raised in July? I guess the risk looks somewhat high that if prepays remains somewhat elevated in your book value, remains under a little bit of pressure because of paydowns that the preferred in your capital structure will just continue to consume a larger proportion of your overall equity base. And you guys have a fairly large chunk of preferred that's costing you more than your overall return on equity?

And I guess there's no free lunch. I realize that there's the potential for that to hit book value if you were to use common to buy back preferred, but I'm just curious how you guys thought about the option to reduce leverage at the overall business level versus just delevering the common investor?

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary [8]

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So when you look at that preferred that we have outstanding and the $100 million of unsecured borrowings that has about almost 20 years to run, the overall cost of that capital is pretty reasonable, around 7.75% so a little bit under that. And that's pretty tough to replace in this environment, even the perpetual preferred market today is a 5-year fixed and floating environment, which, from a permanent capital perspective, is -- we don't view it as nearly as attractive as a perpetually fixed coupon preferred.

And at the levels that are getting done out there, you wouldn't refinance that preferred with the new preferred.

In terms of using common equity to reduce our preferred equity through a redemption of some sort, you could do that but then you're giving up the option of having that mezzanine capital out there when your overall returns exceed that preferred cost of capital.

And on the margin, deploying that capital in -- from runoff or from the equity raise into new securities that are at considerably higher ROE than that preferred cost of capital such that over time, we'll be earning in excess of the preferred cost. That's the plan. And that preferred will once again be accretive to our common returns.

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Operator [9]

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(Operator Instructions). Our next question comes from Steve Delaney with JMP Securities.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research & Senior Research Analyst [10]

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Robert, I was wondering, if we look at Fed funds today at 180, the GCF RMBS rate at 193 or so, where does that put your 30-day repo rate to you from the dealers?

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary [11]

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What we're seeing right now is around 207. And as Phil alluded to in his message, if you look at what we're paying for repo rates versus various short-term money market rates, it's elevated. If you go back over the last 3 or 4 years and look at what we paid in repo over the last 3 or 4 months versus either Fed funds or 1-month LIBOR, we're paying, on a spread basis, 10 to 20 basis points more than you would have expected if those spread would have just remained constant.

So having said that, if the Fed cuts like people expect at the end of October, we would expect that repo rate to drop to, say, 185, which is obviously a positive, but on a spread basis versus where funds and 1-month LIBOR be is still at an elevated spread.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research & Senior Research Analyst [12]

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Yes. And with -- given what we saw in September, I know the Feds responded aggressively, but anything different this year as you approach year-end in terms of -- you got the, yes, it would be nice to lock in now, but you also want to wait for a rate cut, which possibly doesn't come until December.

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary [13]

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Yes. We'll probably proactively manage the repo book or we might extend some roles if we see advantageous rates over year-end. We might not -- we primarily do 30-day stuff, but we see 60- or 90-day rates that look attractive to get us over year-end, we'll probably do some of that trade because it's anybody's guess as to what the funding markets are going to look like at year-end.

I mean I think with the Fed fund, it's been obviously a positive but it was pretty ugly mid-September through the end of the quarter.

And so I still think there's a question of how much of that borrowing rate that primaries were getting through the Fed's repo operations, how much of that they actually passed down to their either other intermediaries or 2 other counterparties.

So we'll just kind of look at that as we go, but we will probably roll some positions a little early just to make sure we are booking and good shape at year-end.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research & Senior Research Analyst [14]

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Got it. Well, given where we are today, at, say, 205, 210 on repo and your new lower 2-year swap rates at the margin as you -- and you brought -- I know you're not looking to actively redeploy. But at the margin, what type of net interest spread would you say you're looking at today?

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Lance J. Phillips, Capstead Mortgage Corporation - Senior VP, CFO, CAO & Secretary [15]

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I'd say we're probably looking at kind of the 90 to 95 basis point area, which, as I mentioned to Eric earlier, even at 8.75, 9x leverage, that's still throwing off 10.5% to 11% type returns.

So we have some dry powder to take advantage if there are opportunities in the fourth quarter, and we are looking to do that. So spreads are still extremely attractive, but obviously, it's because of the conditions in the market, right, because of prepay uncertainty and repo and fed uncertainty. So they look attractive now, but we don't know. But we could take leverage up if we needed to.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research & Senior Research Analyst [16]

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Right. You've got a little flexibility there if you saw a great opportunity. So yes -- and one last -- my last thing. Obviously, I have -- we have here some work to do on our premium amortization, you guys beat us handily in this quarter. So congrats.

Help me understand, we're now with the concept of sort of a lifetime CPR approach. And obviously, speeds were up, but you -- I'm trying to rationalize the fact that you've moved to a more stabilized lifetime approach, but yet in the quarter, you lost 6 basis points, which you attributed primarily that decline to 2.76% from 2.82%, you attributed to higher prepay.

So I'm sort of trying to rationalize, sort of, the lifetime approach but then the impact of quarter-to-quarter changes in speed.

Is there anything straightforward that you can say about that? I know it's a pretty complicated calculation.

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [17]

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I don't know what all we can tell you. We're amortizing under our effective yield method with a lifetime speed assumption, and so the level yield calculation pretty much throws out what your amortization is going to do. And that's just how it rose. So you're seeing less -- you're seeing a more -- a less aggressive amortization of our premium than from years ago and we think that's appropriate. And...

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research & Senior Research Analyst [18]

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Oh, yes, I'm not questioning it. I totally think it's appropriate. And I was just trying to rationalize the 2. What I'm hearing you say, Phil, is while you have a lifetime expectation, you are still going to be impacted in terms of amortization based on actual speed. Is that -- so I think I was...

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [19]

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That's absolutely right. That's the way it should be. You've got -- if you're running low or high, that's going to have an incremental impact on your overall effective yield for the life of your investment and will be accounted for in the current period when that occurs.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research & Senior Research Analyst [20]

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Okay. Well, I think I'll follow up when I'm going through -- I think I'll follow up with Lance and just see how we can tighten things up. And just -- I said last, but just one final thing. Your swap, your repositioning of your swaps in the quarter, do you have any estimate of what impact that, that had on either GAAP or core earnings?

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Phillip A. Reinsch, Capstead Mortgage Corporation - President, CEO & Director [21]

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Well, we tried to give a data point that would help you get there by indicating what our average fixed swap rate was of 2.14% average fixed, and at the end of the quarter, it stood at 2.04%.

Now we do have some swaps burning off in the fourth quarter that are at lower levels so that will impact future swap rates as well. But that should be able to help you quantify to some extent.

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Operator [22]

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This concludes the question-and-answer session. I would like to turn the conference back over to Lindsey Crabbe for any closing remarks.

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Lindsey Crabbe, Capstead Mortgage Corporation - Manager, IR [23]

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

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Operator [24]

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