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ARMOUR Residential REIT (NYSE:ARR)
Q3 2019 Earnings Call
Oct 24, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Greetings, and welcome to the ARMOUR Residential REIT, Inc. third-quarter 2019 earnings conference call. [Operator instructions] As a reminder, this conference is being recorded on Thursday, October 24, 2019. It's my pleasure to turn the conference over to Jim Mountain, chief financial officer.

Please go ahead, sir.

Jim Mountain -- Chief Financial Officer

Thank you, operator, and thank you all for joining our call to discuss ARMOUR's third-quarter 2019 results. This morning, I'm joined by ARMOUR's co-CEOs, Scott Ulm and Jeff Zimmer; and Mark Gruber, our COO and CIO. By now, everyone has access to ARMOUR's earnings release and Form 10-Q, which can be found on ARMOUR's website, www.armourreit.com. This conference call may contain statements that are not recitations of historical fact, and therefore, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

All such forward-looking statements are intended to be subject to the safe harbor protections provided by the reform act. Actual outcomes and results could differ materially from the outcomes and results expressed or implied by these forward-looking statements due to the impact of many factors beyond the control of ARMOUR. Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports filed with the Securities and Exchange Commission. Copies are available on ARMOUR's website at -- or on the SEC's website at www.sec.gov.

All forward-looking statements included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements unless required to do so by law. Also, our discussion today may include reference to certain non-GAAP measures. A reconciliation of these measures with the most comparable GAAP measures is included in our earnings release, which can also be found on ARMOUR's website.

An online replay of this conference call will be available on ARMOUR's website shortly and will continue for one year. ARMOUR's Q3 GAAP net loss was $61 million or $1.09 per common share. The net loss was driven primarily by $81.2 million of adverse mark-to-market movements of our interest rate swaps, while the favorable $93.9 million mark on our available-for-sale securities flows through other comprehensive income. Our core income, which excludes those mark-to-market items but includes TBA drop income, was $35.9 million or $0.55 per common share.

For the last 13 quarters, our core earnings have consistently exceeded dividends. Looking forward, we also expect that for the full year of 2019, core income will exceed dividends. Through September 30th, that excess totals $42 million, which represents about $0.71 per common share outstanding at quarter end for those 13 consecutive quarters. Based on stockholders' equity at the beginning of the quarter, core income represents an annualized ROE of 10.4%.

During the quarter, we repurchased 330,000 common shares of ARMOUR stock for $5.6 million. That added $0.02 per share to our book value. During the quarter, we completed the redemption of $54.5 million of our 8.125% Series A cumulative redeemable preferred stock, which we had previously announced in Q2. We've also issued 696,479 shares of our 7.875% Series B cumulative redeemable preferred stock under our preferred B ATM sales agreement.

ARMOUR's quarter-end agency portfolio consists of over $12 billion of mortgage-backed securities. Quarter-end book value was $20.43 per common share, down 0.3% for the quarter as the positive impact on book value from rates was fully offset by the impact of spreads and pay downs, reflecting our losses on interest rate contracts and partially offset by gains on the agency securities. Net of hedging, the excess core income and over our dividends paid also contributed. GAAP book value at October 22, 2019, was estimated at $19.76 per common share outstanding.

Remember that we included recent book value estimates in our update presentations available on our website or EDGAR, usually around the middle of the following month. We paid dividends of $0.17 per common share during each month in the third quarter for a total of $30.3 million or $0.51 per common share. We've announced monthly common dividends for October and November at the rate of $0.17 per common share. Now I'll turn the call over to co-Chief Executive Officer Scott Ulm, to further discuss our portfolio position and current strategy outlook.

Scott Ulm -- Co-Chief Executive Officer

Good morning. The global economic concerns and heightened uncertainty around fed policy from the first half of 2019 continued into the third quarter and still exists today. Despite delivering on two 25-basis-point cuts in the third quarter, the Federal Reserve remained noncommittal to a deeper using cycle, citing low unemployment, strong consumer and housing data and stable GDP. We'll know more on October 30, but the market clearly expects more from the fed.

The market's concerns around a prolonged trade war, weakening global manufacturing and stagnating prices have been manifested in lower treasury yields, higher bond volatility. Note that on December 31 of last year, the U.S. Treasury 10-year note yielded 2.68%, cut as low as 1.46% on September 3rd, then within 10 days, jumped to 1.9% before settling in today's mid-1.7% type of yields. Additionally, the spread between yields on three-month LIBOR and the 10-year treasury, a common measure for the health of the financial system, tumbled from negative 66 basis points, also on September 3rd, underscoring the diversion between the market's pricing and the fed's own outlook.

Today, the spread stands at circa negative 20 basis points. Note that the average for the preceding 12 months was negative 11 basis points. We anticipate the Federal Reserve Committee to follow up with at least one more 25-basis-point decrease in overnight borrowing cost by the year's end. Federal funds futures indicate an 89% chance of a 25-basis-point rate cut in October.

The mortgage refi machine reached full speed by August, as measured by the MBA refinancing index, touching levels last seen in 2016. The average prepayment rate on our agency assets increased from 7.3 CPR in the second quarter of 2019 to 13.3 CPR in the third quarter. Given the current level of mortgage rates and available capacity to originate new loans, we project speeds to start receding by early next year as borrower burnout and seasonal factors mute the fastest of speeds. We note that over 80% of our agency portfolio is prepay protected through superior asset characteristics of those of TBA or generic new production bonds, which are the most risk to refinance.

A percent of this drop in mortgage rates raised expectations for a significant supply of new MBS and faster mortgage prepayments resulting in a drastic reduction of MBS durations and wider spreads. Despite increased volatility and worsening negative convexity of MBS, ARR maintained a positive average duration gap of plus 0.4 throughout the third quarter to meaningfully offset any losses coming from spreads and convexity. In the third quarter, ARR's agency MBS holdings widened by 11 basis points in option-adjusted spread. The agency DUS portfolio during the third quarter saw a more modest widening of three basis points, where the positive convexity attribute -- contributes a significant diversification of the portfolio.

Similarly, our non-agency and CRT holdings also widened by just three basis points during the third quarter, although inter-quarter volatility in spreads presented us with several opportunities to add seasoned CRT vintages when the market prepayment fears exceeded our own projections. A technical drop in broader United States Banking and Financial Corporation's available liquidity reserves in mid-September saw funding markets experience their first real big challenge in a decade. On September 17, MBS repo saw highs on 10% and averaged over 6% for the day. Concerns around the quarter and year-end funding emerged, and the fed quickly responded by injecting liquidity via sizable reverse repo operation.

Although we saw our counterparties raise rates during this period of heightened volatility, our affiliated broker-dealer, Buckler Securities, was able to provide us stable financing alternatives. This is exactly the situation for which we created Buckler and has served us very well in these volatile circumstances. In the third quarter, mortgage spreads have continued to lag those in securitized credit, highlighting concerns around gross and net supply volatility, as well as negative complexity embedded in the sector. At current valuations, the risk reward of owning MBS has clearly moved toward the attractive territory.

Mortgage-backed securities OAS has reached wide last season three years ago. The beginning of the fourth quarter saw further widening, with OAS jumping nine basis points and swap rates widening by 12 basis points. Overall, we look to yield curve normalization, and the decline in rate volatility is necessary signals for outperformance in the sector in 2020. Despite the volatility of the current environment, we remain constructive on our prospects to create value for our shareholders and expect that our year 2019 core earnings will exceed our dividends declared and paid.

Some of the factors we have to deal with should abate in the coming months. Prepayments burnout, the Fed realizes the issues with repo and is taking concrete and substantial steps to stabilize the market. The trend in short-term rates is down, suggesting we'll see a more positive yield curve for our investments in funding, particularly if repo rates behave more normally. And the spread environment is historically wide.

Taken as a whole, these factors suggest an overall improving environment for our business. Operator, that concludes our prepared remarks. We'll now take questions.

Questions & Answers:


Operator

[Operator instructions] And our first question comes from the line of Douglas Harter with Credit Suisse. Please proceed with your question.

Douglas Harter -- Credit Suisse -- Analyst

Thanks. Can you talk about your expectations for how much more your prepay speeds might increase in the fourth quarter?

Jeff Zimmer -- Co-Chief Executive Officer

Sure. And that's probably -- Doug, it's Jeff. It's probably part of a broader question regarding NIM, which we get from investors and analysts when they call the office. So we'll talk about that.

We expect November prepayments to exceed October prepayments by between 5% and 15%, and we're zeroing in on the middle of that range. We expect prepayments thereafter to drop from those levels due to capacity constraints, that Scott talked about in his comments a couple of minutes ago, investor burnout. In other words, refinance burnout, I think, is a better way to say that. And then the third element of that is the mortgage rate hovered around 361 for quite a while.

It's been between 382 and 386 today, depending on which source you look at. So you will see prepayments normalize as we move into the first quarter. Now of course, you could see them get way lower if rates go up a little bit more, and you could see them get faster, of course, if rates go down a little bit more. So looking at NIM, if you want to move on to a more holistic question, I think there'll be four components to a positive perspective on NIM looking out over the next couple of quarters.

Prepayment is normalizing, which I just discussed. The fed rate cuts will help the curve steepen and, in turn, will help repo normalization. And repo rates are trading higher than fed funds rates based on historical. So the fed funds target was 1.75, repo should be closer than about to the 2 to 2.05 areas that we're trading depending on the tenor.

And then the fourth thing is OAS have widened out a lot. Zero OAS on June 19 was 52 basis points. Then the current coupon follows which is like a two and a half or three depending on your date, OK? They're 98 yesterday, a big widener. So they provide some opportunities.

So despite the fact that there was -- and I've noticed in your report this morning, the book value changed in the fourth quarter. Fannie 2.5 has the current coupon widened three OAS since the end of the quarter. However, the ARMOUR portfolio widened nine OAS. And I would suggest that the book value change in the fourth quarter so far would be 85% of that is spread and 15% of that the increase in rates.

If you look at our monthly company update, you can see that the average net coupon, the 30-year assets, is 4%, so it's like a 4.60%, 4.62% gross rate. So those are the assets that performed -- underperformed over the last couple of weeks. So when you're looking at doing analysis, don't look at what the brokers say the current coupon is doing because that's going to trade more like a treasury for a while, like it has a 99 handle on it. So anyway, that's a long answer to your short question.

Douglas Harter -- Credit Suisse -- Analyst

Great. And then just sort of still within the spread question. You mentioned a little bit about Buckler Securities. Can you just talk about kind of how you see funding differentials between Buckler and Street repo today?

Jeff Zimmer -- Co-Chief Executive Officer

Yes. Doug, Buckler's funding is, I'd say, broadly consistent with The Street. Sometimes a little better, sometimes a little wider. It depends on the day.

It depends on the market. The principal difference, taken as a whole, though, is we have -- we're comfortable having funding open overnight with Buckler, something we wouldn't do with a third party where we live by the grace of them granting us balance sheet. We're highly confident of Buckler's ability to fund. And the ability to have open really gives us the opportunity to execute on opportunities that appear in the market, which we wouldn't have if we were, say, termed out 30 days at a time.

So there's a very interesting sort of option for that. And while it hasn't been true with the inversion in funding markets open in quotes normal times often offer a pretty substantial funding advantage, too.

Douglas Harter -- Credit Suisse -- Analyst

Great. Thank you.

Operator

Thank you, sir. Continuing on, our next question comes from the line of Trevor Cranston with JMP Securities. Please proceed.

Trevor Cranston -- JMP Securities -- Analyst

Hi. A couple of questions on the repo market. I guess the first part is, can you say if you think that the spike we saw, I guess, in mid-September, had any measurable adverse impact on third-quarter results? And specifically, I'm thinking of -- it looks like leverage kind of ticked down over September, and I was wondering if that was related to possibly not wanting to roll repo at higher rates? And then the second part of the question is kind of how you guys are thinking about the repo market heading into year end? And if you're approaching that any different than normal and maybe pre-emptively looking at extending repo across year end?

Jeff Zimmer -- Co-Chief Executive Officer

So I'll echo Scott's comments on the power of having our own affiliated broker-dealer. We have a third of our book right now already well into January 2020. Because we have our own broker-dealer, we're always confident of getting overnight funding. We've maintained about two-thirds of it on a shorter scale.

And of that two-thirds of 65%, I think, with Buckler. As we get into the Fed moves here and we look at what things do over the year end, we'll slowly kind of move out, but not the entire book. We're very comfortable having always access through the FICC that most other REITs just don't have. Now in terms of -- your first question was normalizing on repo.

Repo should trade tighter to fit funds, then it should trade tighter now because it has traded tighter in the past. The over year end of the situation being like the September 16 and 17 situation, we do anticipate some dislocation, but we're very comfortable with the structure that we have to be able to solve any problems with that dislocation. And the earnings effect of the September 16, 17 is so negligible, it's not even worth bringing up, way, way less than $0.05.

Trevor Cranston -- JMP Securities -- Analyst

OK. Gotcha. So would you say the sort of half-turn drop in leverage, is that just sort of normal portfolio management? Or is that kind of a level you guys are anticipating running at going through the fourth quarter?

Jeff Zimmer -- Co-Chief Executive Officer

So I talked about it on the last earnings call, and I'll repeat it again. So even though it looks like we only bought 5.6 million back of ARMOUR stock in the third quarter, we bought 54.5 million back of the Series Preferred A. So if you take that kind of times -- 9x leverage, that's $500 million worth of reinvestment we did not have to make. We felt that mortgages were going to widen.

We said so in the last quarterly call. Mortgages have widened. We've led our portfolio runoff. We now have dry powder, and we may opportunistically, as we see what the Fed does here and the curve may be steepening a little bit, put some money to work in agency mortgage-backed securities.

As I said, they're the widest 0 OAS spreads they've been in three years. So you might see leverage go up a little bit from where we are right now but certainly not more than a turn. And we may finish the end of the quarter just where we are right now if we don't find the right entry point.

Trevor Cranston -- JMP Securities -- Analyst

Gotcha. OK. That's helpful. And then in terms of how you guys are approaching interest rate risk management, can you comment on how you would expect the portfolio to perform in an upgrade scenario versus a downgrade scenario? And generally, kind of how you think about the balance of those two risks and the extension risk within the portfolio?

Jeff Zimmer -- Co-Chief Executive Officer

We have many charts that show what our book value does and how our portfolio performs in up and down markets. And it's pretty even between 25 basis points and up and 25 basis points down, so you would just have a nominal move in book value. But when we do those charts, they don't account for the fact that the mortgage book written in 1978 says the mortgage is supposed to tighten when rates go up, but they didn't do that in the first three weeks of the fourth quarter. And generally, though, they would.

And the reason they didn't is because there's still heightened awareness of heavy prepayments, which put pressure on things like 3.5 coupons that have 460 gross WACs on them, which is kind of what the new TBA origination is right now.

Trevor Cranston -- JMP Securities -- Analyst

OK. Gotcha. I appreciate the comments. Thank you.

Jeff Zimmer -- Co-Chief Executive Officer

Thank you.

Operator

Thank you. Continuing on, our next question comes from the line of Christopher Nolan with Ladenburg Thalmann & Company. Please proceed.

Christopher Nolan -- Ladenburg Thalmann & Company -- Analyst

What's the thought process right now for additional share repurchases in the fourth quarter?

Jeff Zimmer -- Co-Chief Executive Officer

We're trading quite a bit under book, and we will selectively buy back shares. Remember, we just spent $60 million in the third quarter, which is quite a bit of money. And we'll be selective, but we'll buy back shares. I think it has been -- it's funny.

It's accretive and not as much as you think. And to make like ridiculously accretive, you got to spend so much, your cost ratio starts to go up. So we'll buy back. It's good for shareholders.

It's accretive to book value, and we'll continue to do so for trading these kinds of discounts.

Christopher Nolan -- Ladenburg Thalmann & Company -- Analyst

OK. And just following up on Trevor's question on the leverage. Am I interpreting correctly that you're not really expecting much in the way of a change in leverage? I mean, it all depends on if you see an attractive entry point? But it sounds like you're trying to position the portfolio just to maximize your option sometime in the next two or three quarters. Is that a fair way of looking at it?

Jeff Zimmer -- Co-Chief Executive Officer

Yes. And to be further to that point, just to reiterate, we bought back the Series A preferred. So we didn't have to reinvest for especially the last three to four months in a period where we expected mortgages to widen out. We had a proclivity toward widening.

So now that risk has been avoided. That's why our book value performance in this quarter was so good versus what we believe our expectations were. We will only increase our leverage if we see some good opportunities. Remember, it's just not LOAS.

It's just not OAS. It has to be between OAS, where the hedging opportunities are as well as where the funding rates are. So if we get that holistic opportunity, we'll go ahead and spend some money, and you could see leverage go up. Now we have not reinvested, as I said, for the last couple of months.

So the first thing we'd be looking at is do we want to reinvest for November or December pay downs before we would even be taking up leverage. So I hope that's helpful.

Christopher Nolan -- Ladenburg Thalmann & Company -- Analyst

Great. Thank you.

Operator

Thank you. [Operator instructions] Our next question comes from the line of Matthew Howlett with Instinet. Please proceed with your question.

Matthew Howlett -- Nomura Instinet -- Analyst

Thanks for taking my question. Good morning. Just, Jeff, you talked about some positive guidance in terms of possibly next year margins are improving or the outlook improving. I just want to follow on that.

I know you don't give margin guidance, but could the margin sort of bottom here in the second half of the year and sort of begin improving next year? Is that sort of how to think about the trend in margin?

Jeff Zimmer -- Co-Chief Executive Officer

This is what we see as the future. You should see some sort of bottoming here, I would think, in the fourth quarter. If the elements that are very positive that we discussed for some reason don't realize, all of a sudden, the 10-year's a 115 10-year, the fed doesn't cut. The curve gets inverted.

Those are things we don't expect to have happened. But if things that we expect to have happened, which are very realistic propositions, that would be our thought that you should see NIM bottom out in the fourth quarter, perhaps the first quarter.

Matthew Howlett -- Nomura Instinet -- Analyst

Got it. OK. And then like you said, you talked about value in the mortgage-backed market. Is there any -- are we talking about specified pools? Are there certain areas in the pay up that you see more value? And then in certain areas other than other areas, just curious on that -- on your outlook.

Jeff Zimmer -- Co-Chief Executive Officer

I want to be careful here because we are doing some reinvesting of pay downs right now. We did spend a few hundred million dollars in the last few days in one area of the specified market. We look at it versus everything. Dollar rolls, which may kind of look good to some people in some respects, are not good versus specified pools.

Some specified pools are trading two points over TBA. Those are pools that we would have bought a year ago at up 8.125. We don't buy those anymore. But there are certain areas that we believe are modestly undervalued, do not cost so much more than TBAs that we look as good investments with nice convexity features.

Matthew Howlett -- Nomura Instinet -- Analyst

Got it. And then I noticed a short TBA position. Is that something we expect is going to be an ongoing part of the portfolio looking out?

Jeff Zimmer -- Co-Chief Executive Officer

Yes. The short TBA position represents some higher coupon assets that if the market rallied against us, we have assets that aren't performing well that we could deliver into that. Otherwise -- so it's an inverted role curve. So think about this.

Normally, you're a mortgage banker and you're selling your Fannie 3s and Fannie 2.5s out in the future. OK? And you're selling them at 102 in September. And in October, they're 101.24. In November, they're 101.5.

Well, if you look at the 4s in particular, the 4s are inverted because people expect high prepayments and poor performance. So you can sell 4s out two, three, four months, in theory, at higher prices. That gives you an opportunity to put on the kind of trade we do. And I guess the big market enrolls, we know everybody else knows that, but just to be clear of the type of thing that you could see us do when things get different than has been typical.

Matthew Howlett -- Nomura Instinet -- Analyst

Great. Got it. I think that's it. Thank you.

Operator

Thank you. I'll now turn the presentation back to Mr. Mountain to continue your presentation or for your concluding remarks. Thank you.

Jim Mountain -- Chief Financial Officer

Thank you, operator, and thank you, everybody, for joining us. As always, we appreciate your interest in ARMOUR Residential REIT. And if you've ever got any questions, please feel free to give us a call at the office, we'll try and get back to you promptly. We'll talk to you next time.

Operator

[Operator signoff]

Duration: 28 minutes

Call participants:

Jim Mountain -- Chief Financial Officer

Scott Ulm -- Co-Chief Executive Officer

Douglas Harter -- Credit Suisse -- Analyst

Jeff Zimmer -- Co-Chief Executive Officer

Trevor Cranston -- JMP Securities -- Analyst

Christopher Nolan -- Ladenburg Thalmann & Company -- Analyst

Matthew Howlett -- Nomura Instinet -- Analyst

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