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Capstead Mortgage (NYSE:CMO)
Q2 2019 Earnings Call
Jul 25, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good morning, and welcome to the Capstead second-quarter 2019 earnings conference call. [Operator instructions] Please note that this event is being recorded. I would now like to turn the conference over to Lindsey Crabbe. Please go ahead.

Lindsey Crabbe -- Manager, Investor Relations

Good morning. Thank you for attending Capstead second-quarter earnings conference call. The second-quarter earnings release was issued yesterday, July 24, 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 October 23, 2019. 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, July 25, 2019. The company assumes no obligation to update any statements including any forward-looking statements made during this call. With that, I will turn it over to Phil.

Phil Reinsch -- President and Chief Executive Officer

Thank you, Lindsey. After a few brief remarks, Lance will give a recap of the quarter and then we'll open the call up to questions. Our core earnings held up well this quarter in the face of significant market volatility. As the market recalibrates from expecting 125-basis-point Fed rate cut to now expecting as much as 75 basis points in cuts this year and another 25 basis points or so in 2020.

With the second consecutive $0.12 quarterly earnings sprint, we increased our common dividend by 50% to $0.12 per share this quarter. This reflects our belief that we can produce strong risk-adjusted returns this year and the next, regardless if the Fed reduces the Fed funds rate at the pace anticipated by the market or takes more of a one-and-done stance at its meeting next week. On the one hand, should the Fed reduce the Fed funds rate a number of times as expected by the market, we will benefit significantly considering that our $7.5 billion in swap balances at quarter end represented 70% of our outstanding repo balances, with another $1.25 billion in swaps maturing by year end. This will leave us with plenty of room for our borrowing cost to benefit from rate cuts.

The resulting lower borrowing costs will help insulate earnings from many effects of higher mortgage prepayment activity, spurred by lower prevailing mortgage rates. On the other hand, should the Fed not reduce the Fed funds rate as much as expected, we remain well hedged at a reasonable cost, having effectively banked rate cuts through the liberal use of two- and three-year slots with lower fixed-pay rates relative to unhedged repo rates. This has improved our net interest margins while helping to insulate us from a more hawkish threat -- Fed. Additionally, in this scenario, mortgage prepayment pressure should subside with the market recalibrating to expect higher rates.

A negative of our hedging activities is that we lost value in our swap book on a mark-to-market basis with a swift decline in rates this quarter. This occurred because many of these positions were put on prior to these declines. And agency MBS pricing underperformed due largely to rising expectations for higher mortgage prepayment. Since quarter end, book value has been relatively stable.

These negative marks will dissipate over the terms of these swaps to the benefit of book value and should the Fed disappoint the market by not reducing the Fed funds rate as much as expected, valuations could improve more rapidly. With that, I will turn the call over to Lance.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Thank you, Phil. We incurred a GAAP net loss of $63.5 million this quarter or $0.80 per diluted common share. Our core earnings were $14.8 million or $0.12 per diluted common share. The difference between our GAAP net loss and core earnings primarily reflects realized and unrealized valuation losses on our swap portfolio, as Phil described, as well as certain other amounts excluded from our core earnings metric.

We include a reconciliation of these differences on Page 8 of our press release. Portfolio yields averaged 2.82% during the quarter, an increase of 7 basis points from the 2.75% we reported in the first quarter. Yields directly benefited from higher cash yields on acquisitions as rates on the underlying mortgage loans in our portfolio reset higher, while absorbing the effect of higher mortgage prepayment levels. Our portfolio-related borrowing cost increased 12 basis points over the prior quarter.

This increase was primarily due to higher hedging cost as interest rate swaps with lower fixed rates matured, new swaps were entered into at higher rates and variable rate swap receipts were negatively impacted by declines in three-monthLIBOR. Unhedged borrowing rates were relatively unchanged from the previous quarter. Book value decreased $0.50 per share during the second quarter, ending at $8.93 per common share. The decrease reflects $1.05 decline associated with our hedging activities that was only partially offset by a $0.55 increase in portfolio-related pricing changes.

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

Questions & Answers:


Operator

[Operator instructions] The first question comes from Eric Hagen of KBW. Please go ahead.

Eric Hagen -- KBW -- Analyst

Thanks. Good morning. Two questions on prepayment speeds. Number one, when do you expect speeds to slow? And number two, the slowdown that you're expecting which corresponds to the amount of premium amortization that you're currently booking, what is that prepayment speed expectation? Thank you.

Phil Reinsch -- President and Chief Executive Officer

So prepays are going to remain elevated this summer, and then they'll start to recede in the fourth quarter, we assume. And any amount of decline will depend upon how aggressive the Fed is in cutting rates. And then we would expect some moderation next year.

Eric Hagen -- KBW -- Analyst

OK.

Phil Reinsch -- President and Chief Executive Officer

We don't actually make a disclosure that -- of what our estimated prepayment speed for the future life of our portfolio. I know some guys do, but we have not made that disclosure till date.

Eric Hagen -- KBW -- Analyst

OK. I can appreciate that maybe an exact number isn't something that you want to provide, but the portfolio paid down at 26% CPR in the second quarter, that expectation -- or is that something in the low-20s? Is it in the high teens? Is it in the mid-20s? I mean there has to be a range that you can sort of guide us to. Thank you.

Phil Reinsch -- President and Chief Executive Officer

Well, I think, Eric, ARM speed generically, if you look at where we are right now in the mid-20s, so I alluded to earlier, I think the seasonal factors will kick that number up somewhat in the third quarter before declining in the fourth. But right now, you've got an interesting time in the ARM market where you have longer reset securities that were originated in the last year or two where speed assumptions may have gone from 18 to 25 generically. And at the same token, you have very seasoned ARM securities that are resetting down now and estimated life speeds have gone from the mid-20s to the high teens. So you're starting to have a convergence where newer issue longer reset paper is ramping up, at the same time, very seasoned bond, life expectations are going down.

So to take all that in context, I would think the natural progression would be from mid-20s to upper-20s back down to lower-20s. And then over time, depending upon what rates do I think it probably settles in, in aggregate somewhere low-20s to 20% CPR, something like that. I think that would be a projected ramp of ARM speed in the entire market, I think that's kind of what you'd be looking at.

Eric Hagen -- KBW -- Analyst

OK. OK. So we should figure this will go back to the maybe low-20s over time. But I want to hammer in kind of -- or focus in a little on the timing, right? Because since ARM is a such short duration securities and you're presumably booking at higher yield today with the expectation that speeds will eventually slow into that, call it, low-20s range.

And then after how much time or at what point would you be required to take what's effectively a catch-up charge if the slowdown that you're expecting doesn't actually materialize?

Phil Reinsch -- President and Chief Executive Officer

Well, that's -- I don't know if we can really answer that question, whether a catch-up charge would actually be required. We look at our life speeds. We keep an eye on that all the time, and we'll adjust them as we need to. And I wouldn't necessarily anticipate that we would have a sharp change in speed required.

While conservative with our speeds, we've just -- I know the concern is that amortization is a little lower this quarter relative to the pickup in speeds, but as we've discussed last quarter, we've been working to improve our estimation process for prepayments to lessen the impact of cyclicality and seasonality. And we have a large diverse portfolio of ARMS and they're doing different things to different cohorts. Premium levels on recent acquisitions and average outstanding balances are also quite a bit lower at this time, and that also leads to lower amortization costs. So...

Eric Hagen -- KBW -- Analyst

Right. I understand that. But I guess, I'm just trying to understand like the timing around actually realizing what the effective amortization was on the bond relative to your expectations? And when that true-up needs to take place?

Phil Reinsch -- President and Chief Executive Officer

Well, it's happening every quarter, we're true-ing things up. So I don't get the question.

Eric Hagen -- KBW -- Analyst

OK.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Eric, the one thing I think I might say is, we do book to actuals, and that rolls through our core earnings. We do not make an adjustment on premium amortization of catch ups, but every premium dollar we spend does eventually come through timing on core earnings as the bond either is paid or prepaid through its schedule. So I wouldn't expect a catch-up like you're describing. I know others adjust that catch-up plus or minus on their core earnings, but we have traditionally been and continue to be conservative with that.

We just -- whatever dollar we spend on premium will be amortized through core earnings.

Eric Hagen -- KBW -- Analyst

OK. Maybe we can follow up, yeah.

Phil Reinsch -- President and Chief Executive Officer

[Inaudible]

Eric Hagen -- KBW -- Analyst

Yeah. Maybe we can follow-up off-line on kind of the timing aspect of the amortization. But on the swap side...

Phil Reinsch -- President and Chief Executive Officer

Sure.

Eric Hagen -- KBW -- Analyst

The $550 million in swaps that were rolling over this quarter, I assume that's already been rolled. Where along the yield curve did you replace those swaps?

Robert Spears -- Executive Vice President and Chief Investment Officer

We are looking at every swap we've put on in the last how many months or whatever. And we don't necessarily just replace swaps as they roll off. It really depends upon what we're trying to accomplish with our duration gap, are looking at potentially locking in lower financing cost in the future, et cetera. But we have been saying all the swaps that we've been putting on have been in the two- to three-year part of the curve.

We haven't gone any longer or any shorter for the most part. But obviously, we increased our swap position somewhat. And a lot of that at the time was we were looking at swap rates that were cheaper than our implied repo financing. And so, obviously in hindsight, the market ramped up since then, but if you look at our average outstanding swap coupon, it's around two and a quarter or whatever, which is still cheaper than spot repo.

And obviously, the market's pricing it through Fed cuts, and most of that rally came from May to June. And so yes, a do over if you wouldn't want as many swaps on, but we thought that was a still a fairly conservative -- yes, at 70% of our liabilities hedged effectively and then have upside on the remaining 30% if the Fed does cut. Now we will monitor that over time, and we may not be at 70% of our liabilities hedged, it could be less, it could be more. But that's kind of what happened this quarter.

And essentially, the book value decline was, if you just kind of do the simple math on those swaps and assume the swaps had roughly a two-year duration, we lost a little over a point in value on our swaps and on our bonds only improved about a half point because mortgage spreads wide. ARM spread wide in 20 to 25 basis points. And we had roughly 70% of our liability hedged. So if you do the math, it kind of backs into the book value numbers.

Eric Hagen -- KBW -- Analyst

Yep. But just confirming that that $550 million was rolled into a new two-year swap this quarter, and that previous swap had a pay rate of 1.40, and I assume that roughly speaking, the new swap has a pay rate of 1.70, 1.80?

Phil Reinsch -- President and Chief Executive Officer

Well, I think what Robert was saying was it wouldn't necessarily be rolling over the swaps just because they're maturing. We're looking at the total picture, and we may be adding some swaps. We may not be. I think in my remarks, I pointed out that with the Fed looking to reduce rates, we've enjoyed more of that benefit with fewer swaps, and we do have swaps maturing one year ahead.

Eric Hagen -- KBW -- Analyst

OK. And where are you guys rolling one-month repo today?

Robert Spears -- Executive Vice President and Chief Investment Officer

Well, that's kind of a moving target with most recent stuff that we rolled it a week or so ago. It's pricing and partially a Fed ease, and so kind of the mid-2.40s. We would think that if the Fed does ease 25 basis points next week, we'll be rolling new repo in the 2.30% to 2.35% area.

Eric Hagen -- KBW -- Analyst

OK. All right. Thank you for the comment.s

Robert Spears -- Executive Vice President and Chief Investment Officer

Sure.

Operator

[Operator instructions] The next question comes from Steven Delaney of JMP Securities. Please go ahead.

Steven Delaney -- JMP Securities -- Analyst

Thanks. Hey, good morning, everyone. You are all pretty busy down there in the second quarter on both sides of the balance sheet. So definitely since that you are looking at the environment and trying to shift to the greatest advantage possible.

I guess where I'd like to start is, I'm looking at your reported interest income on the portfolio of $85.1 million, up a little over $1 million. And I'm looking at my model, and obviously, we had higher prepays, and we had a figure closer to $82 million in our model. So a feeling that you guys used to have a rule of thumb where 1% increase in CPR would cost about $0.015 on EPS. And from the comments that you've made this morning, I'm hearing that maybe that we should kind of throw that figure out the window.

It certainly didn't look like it was applicable when you had almost a 6% increase in CPR in the second quarter. Is there a figure that you can give us to quantify the EPS impact of a 1% shift in CPR, either up or down at this time?

Phil Reinsch -- President and Chief Executive Officer

I don't think we can point to a specific figure because it is going to be -- it is going to morph with the level of prepayments we see, higher prepayments are going to result in more amortization. But we have taken some of the cyclicality and seasonality out of the ARM amortization equation with how we estimate the prepays. So...

Steven Delaney -- JMP Securities -- Analyst

Yeah.

Phil Reinsch -- President and Chief Executive Officer

We're definitely not -- you could argue we're not being as conservative, but you could also argue that we were very conservative in the past with how we amortized.

Steven Delaney -- JMP Securities -- Analyst

Well, you were, and it led to, obviously, quarter-to-quarter volatility, right, in terms of just the seasonality regardless of rate moves. And our model is kind of crazy, but it had that down in 1Q, up, up, then down in 4Q, and it's -- it really is -- makes it kind of crazy to follow, especially for people that aren't close to the story as Eric and I might be. But I do appreciate your comment. You are saying in your earlier response about your methodology for premium, and I'm hearing you clearly convey that you are on an -- and I'm not trying to put words in your-- these are my words not yours, Phil, that you were trying to smooth out the impact of quarter-to-quarter CPR volatility to get something -- some sort of a smoothing, if you will, that is kind of a true-up on an annual basis as opposed to the big quarter to quarter.

So I think that what -- from a modeling purpose, we need to do is to come to more of a -- if the range of your CPR, just to be simplistic, if it was going to be 20% at the low and 26% or 27% at the high, I probably would take the midpoint around 23-ish or something like that and just change my quarterly CPR to something along those lines. And I'm curious if what -- is this -- is that type of approach sound like the advice that you would give to new analysts that decide to come in and pick up coverage on CMO?

Lance Phillips -- Senior Vice President and Chief Financial Officer

Yes. Steve, this is Lance.

Steven Delaney -- JMP Securities -- Analyst

Hi, Lance.

Lance Phillips -- Senior Vice President and Chief Financial Officer

I would say that's fair. I think one of the things we're real careful on, we've looked hard at our estimates. And as Phil described a couple times, we have tried to not move those estimates with the latest news and look more of the lifetime estimate. In that lifetime estimate, I think, ultimately you could model generically something similar to what you described because we have a longer horizon in those estimates.

And...

Steven Delaney -- JMP Securities -- Analyst

Well, that's helpful. And I'm glad you used -- I didn't want to use the term lifetime because life is -- can be long. But I appreciate that's -- that is the context I think that many of your peers use as they -- quarter to quarter, but it's a lifetime assumption. Some disclose it, some don't, but that concept is -- I appreciate the fact you used that phrase because it helps me understand kind of where you guys are on this.

Lance Phillips -- Senior Vice President and Chief Financial Officer

No. That's good, Steve. And ARMs are unique. So while I will use that, I also will caveat to say that those lifetime estimates continue to be a challenge, and something as Phil mentioned, we've looked at on a regular basis to try and do the best we can with it.

But I -- hopefully, that gives you some help for modeling purposes.

Steven Delaney -- JMP Securities -- Analyst

Yeah. And Robert, thank you for your comments on repo. We had assumed that it -- the market had not really fully priced in a cut, but it sounds like you are getting some relief from where we may be worth 30 days ago already in your mid-40s.

Robert Spears -- Executive Vice President and Chief Investment Officer

It's kind of -- they never priced and anticipated. You know it's been brought to -- pricing over a course of time.

Steven Delaney -- JMP Securities -- Analyst

Yes, of course, LIBOR prices it at all in, right? Because LIBOR is a real market and the dealers just sit there and say, "Oh, we don't owe you anything, the Fed hadn't done anything." So I get it, but we'll work with that 2.30%, 2.35% going into the -- toward the August, September time frame. It sounds like we're pretty much definitely going to get something here on the 31st. My last, last question guys is, I totally support the -- dropping the hedge accounting and going to core EPS, it's a very positive move in my mind for you to have made that. I just need some -- that was just last quarter and this quarter, you terminated, I want to say, it was an $800 million swap in June.

It looks like there is a -- you have in your GAAP EPS, you have derivative expense of $74.8 million, and then I see three different items in the core reconciliation. And I guess, my question is, it doesn't look like it adds up exactly, but is there anything that is in the core reconciliation that you're adding back, that is not already reflected in your GAAP EPS like a onetimer or something like that?

Phil Reinsch -- President and Chief Executive Officer

Well, we did sell about $300 million of bonds. And so we had $1.4 million of realized portfolio loss that ran through earnings this quarter. Ordinarily, that just would have been an unrealized loss running through book value. The -- there was more realized swap loss because we terminated early $800 million of 30-month to term out swaps and replace them with new 24-month swaps at significantly lower rate.

So that kind of distorted the relationship between the unrealized loss and the realized swap results. So...

Steven Delaney -- JMP Securities -- Analyst

So I guess, from -- that's honing it -- on it, Phil. And the $24.2 million add back for the realized loss, I'm just -- I guess, my question is, is that add back relate -- is there a unrealized -- are you reclassifying unrealized loss to realized loss?

Phil Reinsch -- President and Chief Executive Officer

Well, effectively, we are because you've terminated those positions, so you book a loss as realized. And then the new position that came on puts us in the same position effectively from a hedging perspective, but we've locked in the lower fixed pay rates on the new swaps. Now that duration -- we actually reduced our term on those swaps, which was very important to the -- doing the trade. So we went from 30 months to 24 on that component.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Steve, I'm...

Steven Delaney -- JMP Securities -- Analyst

OK. And you -- go ahead, Lance.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Phil's answer is absolutely correct. I just want to make sure that was realized in GAAP, and we noted as realized in core earnings. So there's no swap between unrealized -- or no switch between unrealized and GAAP and realized and core earnings. I want to make sure that if that's what...

Phil Reinsch -- President and Chief Executive Officer

Yeah. Core continues to include the cash flows of the active swaps, right? And that $6.7 million positive is just running off the gain in that -- those swaps that were there when we ceased hedge accounting at the end of February.

Steven Delaney -- JMP Securities -- Analyst

Correct. I remember that that we would have that each quarter for a while, so that is runoff. So OK, guys, look, thanks for the comments. If I have anything else as we're going through the model, I will reach out.

Thank you.

Operator

Our next question comes from Gabe Poggi of Shoals Capital. Please go ahead.

Gabe Poggi -- Shoals Capital -- Analyst

Hey, guys. Thanks for taking the question. I appreciate that you guys are going to provide a -- to Eric's and Steve's point of what the estimated. How you guys are thinking about estimated prepays going forward? And Lance, you noted kind of a lifetime adjustment.

Can you talk about what assumptions go into that assumption, specifically, how you guys are thinking about the forward shape of the mortgage curve? And what I'm getting at is, talk about the Fed lowering rates and obviously, we'll probably get 25 basis points next week, but I'm trying to get a gauge as what happens if the long end of the curve follows suit and we just continue to get a big flattener. And how you guys think about that in conjunction with those prepayment estimates? Thank you.

Phil Reinsch -- President and Chief Executive Officer

Sure. I mean we're on estimated prepay speeds on three or four different models. And to start out, there is not a uniform consensus on our improved payments out there, and there is not much time spent modeling on prepayments as there is fixed. So there are a lot of moving parts, and you can get three different answers on three different models.

And so when we're looking at things, we will model them to the forward curve and to the static curve and at a given point in time. Obviously if the long end inverts, those models are going to kick up speeds, for an instance, more on certain bonds than others. Right now, what's going on in ARMs, as I said earlier, very seasoned bonds, some of these guys are seeing their mortgage rate drop 75 to 100 basis points from where they reset last year. And because of that and where the forwards are right now, it assumes those bonds -- if you look at the life speed on those bonds now versus six months ago, they are a lot slower.

Conversely, if you take, call it, a new issue set on the line with 3.5% coupon, it may have been model at 15% CPR six months ago, and it might model at 20% to 25% CPR now. So if you -- when we look at it, we look at it versus static and the anticipated forward curve at that point in time, and that's what goes into our lifetime assumption. We don't really -- there are so many potential scenarios out there, we don't model everything, but those are what we look at when we look at life speeds on our bonds.

Gabe Poggi -- Shoals Capital -- Analyst

OK. Guys, I'm just trying to get a gauge on what -- as I understand there's a lot of models out there, but what specifically you guys are focused on to come up with that estimate. Just because you look at the static speeds of the last few months, and they've really ramped and obviously, Steve mentioned it's up 6%, you had 26% CPR. But just thinking about that in conjunction of the new estimate, kind of how you're looking at things now the last two quarters with that change, and I appreciate you're being conservative in the past, but kind of how that -- how you ebb and flow with that depending on the shape of the mortgage curve? I guess the answer is, you're just taking what the forward curve is showing you today and basing it off of that.

And if things change, and I assume you have to make a change. Is that correct?

Phil Reinsch -- President and Chief Executive Officer

Yeah. And we are at a point right now, for instance, where we have bonds that are prepaying at 15 to 17 CPR and models have life speeds as high as 25. We have bonds that are prepaying at 25 right now, where models have life speeds going down to 15. And so you're at very interesting point.

And I mean basically, as I said earlier, newer issue, longer reset paper life speeds are projected to go higher, very seasoned post-reset paper, where they're adjusting now, are projected to go lower. And so you're going to have kind of a convergence between those at -- whatever that speed is, but that's kind of what the trend in the market is right now. And yes, it's totally different than where we were six months ago, and it could be totally different six months from now.

Gabe Poggi -- Shoals Capital -- Analyst

Yeah. Correct me if I'm wrong. Having a lot of the seasoned stuff prepaid pretty fast over the last couple of years or last couple of 18 months or so...

Phil Reinsch -- President and Chief Executive Officer

Yeah, and that's what I'm saying, and so lot of the seasoned -- yeah, a lot of the seasoned paper, it's fed up because the borrowers were seeing their rates increase. And so they sped up beyond what life speeds would have expected. And right now, you're actually seeing, for instance, on our very seasoned ARMs last month, their drop was much more precipitous than other cohorts. They declined as much as 20% from June to July.

And the average ARM cohort declined 6%. So you are starting...

Gabe Poggi -- Shoals Capital -- Analyst

But they were also coming off of a really high prepays, right? They were -- that 20% decline is off of very high speeds.

Phil Reinsch -- President and Chief Executive Officer

Yeah. Well, it depends on the land, the law, etc. But you saw as much as a five CPR drop. So bonds that were prepaying at 30 went to 25, bonds that were prepaying at 25 went to 20 on some seasoned cohorts.

Gabe Poggi -- Shoals Capital -- Analyst

Got it. OK, thank you. That's helpful.

Phil Reinsch -- President and Chief Executive Officer

Sure.

Operator

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

Lindsey Crabbe -- Manager, Investor Relations

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.

Operator

[Operator signoff]

Duration: 37 minutes

Call participants:

Lindsey Crabbe -- Manager, Investor Relations

Phil Reinsch -- President and Chief Executive Officer

Lance Phillips -- Senior Vice President and Chief Financial Officer

Eric Hagen -- KBW -- Analyst

Robert Spears -- Executive Vice President and Chief Investment Officer

Steven Delaney -- JMP Securities -- Analyst

Gabe Poggi -- Shoals Capital -- Analyst

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