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Arlington Asset Investment Corp (AAIC)
Q3Â 2019 Earnings Call
Nov 8, 2019, 9:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good morning. I'd like to welcome everyone to the Arlington Asset Third Quarter 2019 Earnings Call. [Operator Instructions] After the Company's remarks, we will open the floor for questions. [Operator Instructions]
I would now like to turn the conference over to Richard Konzmann. Mr. Konzmann, you may begin.
Richard Konzmann -- Executive Vice President and Chief Financial Officer
Thank you very much and good morning, Rich Konzmann, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future financial or business performance, market conditions, business strategies or expectations and any other guidance on present or future periods constitute forward-looking statements that are subject to a number of factors, risks and uncertainties that might cause actual results to differ materially from stated expectations or current circumstances. These forward-looking statements are based on management's belief, assumptions and expectations, which are subject to change, risk and uncertainty as a result of possible events or factors. These and other material risks are described in the Company's annual report on Form 10-K and other documents filed by the Company with the SEC from time-to-time, which are available from the Company and from the SEC and you should read and understand these risks 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 and Chief Executive Officer
Thank you, Rich. Good morning and welcome to the third quarter 2019 earnings call for Arlington Asset. Also joining me on the call today is Brian Bowers, our Chief Investment Officer. During the third quarter, the continuation of a weakening global economic outlook ongoing trade tensions and declining inflation expectations led the Federal Reserve to lower its target fed funds rate twice during the quarter and once again at the end of October. Despite these actions by the Fed the yield curve continue to flatten during the quarter. The two to 10 year treasury curve declined by 22 basis points to 4 basis point as of quarter end, as the weakening economic outlook drove long-term interest rates meaningfully lower leading to heightened interest rate volatility.
Intra-quarter, the 10-year treasury rate fell 55 basis points to 146 basis points in early September before retracing some of that rally to close at 1.66% as of September 30, a decline of 35 basis points during the quarter. Prepayment speeds on mortgages, increased significantly during the quarter in response to the strong rally in interest rates through the course of the year, as well as normal seasonal patterns. In mid-September, a much-publicized market dislocation in the repo funding markets led to a substantial spike in overnight government repo rates, the Fed responded by adding substantial liquidity to stabilize repo funding markets through its open repo market operations and announcing its intentions to expand its balance sheet a very positive step for funding in our business.
High prepayment at speed expectations heightened interest rate volatility on a flat interest rate curve led to an increase in risk premium in mortgages resulting in agency MBS underperforming interest rate hedges during the third quarter. While the Company shift an investment concentration toward lower coupon and specified agency securities, mitigated the impact of the Company's results for the quarter both higher coupon and generic TBA agency securities, under-performed lower coupon and specified agency MBS with favorable prepayment characteristics during the quarter.
Since September 30, agency MBS performance relative to interest rate hedges has been flat to modestly improve. The continued flattening of the interest rate curve elevated prepayment speeds and higher repo funding rates relative to LIBOR, had the effect of compressing net interest spread returns on levered agency MBS during the quarter. However, while these pressures continue to weigh on portfolio returns since September 30, funding conditions have eased and return opportunities on new investments have improved as yield curve has steepen, repo funding rates have declined materially and agency MBS spread widening during the third quarter is captured on new investments.
Turning to our actual results for the quarter, we reported a GAAP net loss of $0.23 per share and core operating income of $0.18 per share. As of September 30, book value was $7.35 per share, reflecting the modest widening of agency MBS spreads relative to benchmark interest rates. Short-term recourse leverage, measured as the Company's repo financing and TBA commitments, less cash to total investable capital was 9.9 times as of September 30. The decline in core operating income from the second quarter was due primarily to lower average leverage and lower average asset yields, partially offset by more favorable net funding costs.
The Company's average leverage during the third quarter was 10.1 times, a decrease of over 1.5 turns from the prior quarter. The weighted average CPR for our specified agency MBS was 12.85% during the third quarter, an increase from 10.16% during the prior quarter. As a result of these higher prepayment speeds, as well as the shift to lower coupon agency securities, the weighted average effective asset yield on our agency MBS portfolio was 2.96% for the quarter, a decline from 3.21% in the prior quarter. The Company's weighted average CPR for October and November was 13.46% [Phonetic], which we expect could result in a weighted average effective yield of approximately 2.78% for that period.
Given current interest rate levels, we expect continued elevated prepayment speeds. But our transition to additional lower coupon specified pool securities with lower premiums should moderate increases in prepayment speeds going forward. The Company's continued shift toward lower coupon securities that carry lower premiums and prepayment risk increase the Company's agency MBS concentration in lower coupon 2.5%, 3% and 3.5% MBS to 57% of its total investment portfolio at September 30, an increase from 27% as of the prior quarter-end. The Company also increased its portfolio concentration of specified agency MBS with low prepayment characteristics during the third quarter, while significantly decreasing its exposure to generic agency TBA, that carry higher prepayment risk. As of quarter end, 98% of the Company's agency MBS portfolio is comprised of specified agency MBS, compared to 86% as of the prior quarter-end. While repo rates were lower during the third quarter, reducing interest expense on unhedged repo, repo rates relative to LIBOR remained somewhat elevated and above the receive rate on the Company's interest rate swaps, offsetting the repo interest benefit in that period.
During the third quarter, the Company's weighted average repo rate was 2.46%, an improvement from 2.64% in the prior quarter. However, as a result of the Fed's actions to both lower the federal funds rate by 75 basis points, since the start of the third quarter and to provide substantial liquidity to the repo markets. Current repo funding rates and conditions have improved materially. Today, one month repo funding rates have improved to approximately 185 basis point versus the average rate on our repo balance at September 30, up 235 basis points.
As a reminder, the Company enters into interest rate swaps, for which it pays a fixed rate and receives variable rate based on three-month LIBOR, in order to lock-in its funding cost for a portion of its repo funding for the length of the swap. From late in the second quarter through the third quarter the interest rate swap market priced in expectations from multiple Federal Reserve cuts, leading to a significant inversion in the short end of the interest rate swap curve versus repo funding cost. The Company took advantage of this opportunity by increasing its short-term rate swap positions by approximately $1.1 billion, during that period to effectively lock-in much of the markets previously anticipated Federal Reserve cuts into its net funding costs.
As of September 30, 81% of the Company's repo funding was hedged with interest rate swaps. And as a result, the Company's weighted average fixed pay rate of its interest rate swaps was 1.82% during the third quarter, a decrease from 2.1% during the prior quarter. While spread pressures for agency MBS do remain, the outlook for return opportunities on new investments today has improved for several reasons. First the Fed's three rate cuts since the start of the third quarter of lowered current funding cost appreciably. Second the Fed's recent actions to stabilize the repo markets have improved repo rates relative to LIBOR, benefiting net funding costs for agency MBS.
Third, the widening of one month to three-month LIBOR since quarter-end also benefits net hedged funding costs. Fourth, the yield curve is steepened with the 2 to 10 year treasury widening over 20 basis points in September 30. And fifth, the mortgage prepayment speed expectations have begun to moderate. In summary, the Company is positioned to benefit from improvements in current net spread opportunities in agency MBS, which should allow the Company to deliver attractive returns to its shareholders.
Operator, I would now like to open the call for questions.
Questions and Answers:
Operator
At this time, we'll open the floor for questions. [Operator Instructions] Our first question comes from Jason Stewart with Jones Trading.
Jason Stewart -- Jones Trading -- Analyst
Hey, good morning guys.
J. Rock Tonkel -- President and Chief Executive Officer
Good morning, Jason.
Jason Stewart -- Jones Trading -- Analyst
On the leverage, on -- in the quarter I mean net settlements, it looked like, took leverage down on average through the quarter but at period end we're sort of heading into this environment where you've listed a lot of positives leverage is already up. I guess my question is, are you comfortable with where it should average out during the fourth quarter based on the September 30 or is there more opportunity to increase leverage based on your view of the investment environment?
J. Rock Tonkel -- President and Chief Executive Officer
I think, Jason there is certainly the potential to increase leverage, some. I'm not sure I would suggest people to expect that. I think we may. I think it's just as likely that we remain about where we are, or about where we sort of were at the beginning of the quarter, which was somewhat increased from the third quarter -- excuse me, from the second quarter, but roughly in line with the third quarter end. And with the potential as spread opportunities improve that we may increase that -- at the margin. And I would say, I would emphasize that the margin we've been clear over time that we expected that no one should be surprised over time leverage came down, I think that's been the case. I think we're comfortable approximately where we are, but we do have the flexibility to move up a little bit if we deem it best given spread opportunities.
Jason Stewart -- Jones Trading -- Analyst
Understood, understood. And then on the repo funding we typically see some pressure going into year end as dealers deal with inventories. This year is a little bit different, I think your average repo was a little less than 30 days. Have you started taking anything over year-end, and your comments, it sounded very positive that the markets were functioning well. And I'm just wondering if you've executed over year-end and seeing any prints in that market over that date?
J. Rock Tonkel -- President and Chief Executive Officer
There is year-end, over year-end repo available. I wouldn't say, it's a massively big market from what we can tell. Right now, we have started that process. We expect to increase that process over the course of the month and the quarter. So we've gotten under way but it's not yet clear how deep that market is through year-end. And I think the potential for some pressure over quarter end is still does exist. I think the overall repo market is far healthier than it was. But there are still, there are still the potential for pressures around year-end. We are working on alleviating that ahead of time as best we can and we've begun that process.
Jason Stewart -- Jones Trading -- Analyst
All right, and that's fairly normal. But it's fair to say that you didn't see much impact from the hiccup and you're not necessarily expecting to see much impact outside of a normal seasonality going into the fourth quarter, is that fair?
J. Rock Tonkel -- President and Chief Executive Officer
Yeah, that's fair.
Jason Stewart -- Jones Trading -- Analyst
Okay, cool. Thank you very much. I appreciate it.
J. Rock Tonkel -- President and Chief Executive Officer
And I would say this, we've been pleasantly surprised by the over year-end levels that we have seen so far.
Jason Stewart -- Jones Trading -- Analyst
Great. Thank you.
Operator
Thank you. Our next question comes from Mikhail Goberman with JMP Securities. Mr. Goberman, your line is live.
J. Rock Tonkel -- President and Chief Executive Officer
You got a question, Mikhail and you can hear us, you can feel free to call us offline.
Operator
We'll take our next question from Christopher Nolan with Ladenburg Thalmann.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Rock, given the...
J. Rock Tonkel -- President and Chief Executive Officer
Hey, Chris?
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Hey, Rock. Hey, Rich. Is -- given the migration to mid-coupon RMBS, is the guidance that you gave last quarter for low double-digit, high single-digit returns on book value, still hold or is there a change on that?
J. Rock Tonkel -- President and Chief Executive Officer
Well, there is a lot of variables in that. As you well know, forward curve, how Fed funds and repo spreads play out, those are important and I think the prior question and answer sort of responded to part of that equation. Speeds are relevant portion of that, speeds continue to be elevated and we'll see how that progresses over the course of the fall -- the rest of the fall, pardon me. And when the seasonal pattern start to kick-in, there may still be a bit of pent-up refinancing, that flow through the system in the next month or so. And then maybe after that we start to see the seasonal effects come into play and help out on the yield side with somewhat reduced prepayment at that stage. I think overall that arena for ROE returns, it's probably fair. I think today, the margin they would probably be based on these conditions at the higher end of that range for new investments. But we've also seen that return opportunities have moved around over the course of the last few months as the market is adjusted to new Fed policy. Today they are in fact at the higher end of that range and those are the -- based on the key points that we pointed out in our script.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Okay. Thank you. That's it for me.
Operator
[Operator Instructions] Our next question comes from Mikhail Goberman with JMP Securities.
Mikhail Goberman -- JMP Securities -- Analyst
Hello gentlemen, can you hear me?
J. Rock Tonkel -- President and Chief Executive Officer
Yes, we can.
Mikhail Goberman -- JMP Securities -- Analyst
Excellent. Sorry about that, not sure what happened there. Thanks for taking my question. Can you potentially give an update on book value performance in the fourth quarter so far? What you're seeing?
J. Rock Tonkel -- President and Chief Executive Officer
I think it tracks what I said in the script, mortgage performance through maybe the middle part or maybe a little later part of October was weaker. And since that time has been considerably stronger to the point that I'd say overall since September 30th performance is flat to modestly improve.
Mikhail Goberman -- JMP Securities -- Analyst
Great. Thank you for that. And maybe some thoughts on what you're seeing in TBA versus spec pools today?
J. Rock Tonkel -- President and Chief Executive Officer
Well, today, we would still favor spec pools. The prepayment risk in the TBA side continues to be somewhat challenging. And returns are body through the coupon stack. So we say some are negative, and some are slightly positive, but carry pretty meaningful prepayment risk from the universe, the broader universe. So we would still continue to favor spec pools here.
Mikhail Goberman -- JMP Securities -- Analyst
Got you. Thank you.
J. Rock Tonkel -- President and Chief Executive Officer
For the prepayment protection.
Mikhail Goberman -- JMP Securities -- Analyst
Right. And I apologize if you had recovered this pro forma line cutoff for a minute or two earlier. But what is your outlook for prepay speeds in the fourth quarter? A lot of -- a bunch of your peers have sort of mentioned that, October was pretty high, November could be pretty high as well but you expect kind of a huge seasonal drop in December but as a whole what do you expect for the fourth quarter?
J. Rock Tonkel -- President and Chief Executive Officer
I sort of hit on that with my prior response, I think our best judgement around, it would be that, first of all, the October and November speeds meaning September to October that were reported in early October, November were about the same. They are about relatively flat and we alluded to that in the script, at about 13, a little under 13.5 for us. And we wouldn't be surprised if those elevated speeds continued for a bit later into the year this year than maybe in some others, as a consequence of the pipeline of financing activity -- mortgage financing activity that's built up in the system. So there might be some of that volume to come through from the lower rate environment, over the next month or maybe two, but we would expect after that to see the seasonal effect take place and late in the year those speeds to come down seasonally and through the first quarter. All of that would depend on rate levels of course. So rate levels lower probably equates to higher speeds and rate levels higher probably equates at somewhat lower speeds. But I think from a calendar perspective, we would see elevated speeds through the fourth quarter and then moderating late in the fourth quarter and into the first.
Mikhail Goberman -- JMP Securities -- Analyst
Great. Thank you very much. Thank you for your time.
J. Rock Tonkel -- President and Chief Executive Officer
You bet. Thank you.
Operator
Thank you. Mr. Tonkel. There are no more questions at this time.
J. Rock Tonkel -- President and Chief Executive Officer
Okay, well thank you very much everyone. We appreciate your time. If you have any further thoughts or questions please share them offline. Thank you.
Operator
[Operator Closing Remarks]
Duration: 21 minutes
Call participants:
Richard Konzmann -- Executive Vice President and Chief Financial Officer
J. Rock Tonkel -- President and Chief Executive Officer
Jason Stewart -- Jones Trading -- Analyst
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Mikhail Goberman -- JMP Securities -- Analyst
