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Capstead Mortgage (NYSE:CMO)
Q1 2020 Earnings Call
Apr 30, 2020, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:


Operator

Good day, and welcome to the Capstead Mortgage first-quarter 2020 earnings conference call and webcast. [Operator instructions] Please note, this event is being recorded. I would now like to turn the conference over to Ms. Lindsey Crabbe, director of IR.

The floor is yours, ma'am.

Lindsey Crabbe -- Director of Investor Relations

Good morning. Thank you for attending Capstead's first-quarter earnings conference call. The first-quarter earnings release was issued yesterday, April 29, 2020, 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 July 29, 2020. Details of the replay are included in yesterday's release. On the call 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. To support the health and wellbeing of our employees and community and address the risks associated with the global COVID-19 pandemic, we have implemented our business continuity plan that enables our employees to work remotely.

As such, please be patient with us as we answer questions since not all presenters are together. 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, April 30, 2020.

The company assumes no obligation to update any statements, including any forward-looking statements made during this call. With that, I'll turn it over to Phil.

Phil Reinsch -- President and Chief Executive Officer

Thank you, Lindsey. After my remarks, Lance will give a recap of the quarter, and then we'll open the call up to questions. An unprecedented near total shutdown of the U.S. economy beginning in March due to the COVID-19 pandemic heightened fears of extremely high credit default levels in recession, leading to derisking occurring at all levels of the fixed income markets.

Credit asset pricing came under severe pressure, destabilizing fixed income markets. All financial firms regardless of size or business model were adversely affected. Levered and unlevered investors across the spectrum began a process of derisking and, in many instances, selling their most liquid positions to raise cash to meet margin calls and redemptions. In the mortgage REIT sector, firms are already experiencing liquidity drains due to declining treasury rates, which led to losses on derivatives held for hedging purposes and valuation-based margin calls.

As the crisis deepened, this drain on liquidity became more pronounced and included increased base margin requirements for swaps due to heightened market volatility. Selling of agency MBS intensified as credit-sensitive mortgage REITs try to avoid realizing greater losses from selling less liquid non-agency positions, eventually disrupting trading in the agency MBS markets due to the sheer volume of sellers and a lack of buyers. The end result was sharply falling MBS prices even as market interest rates declined. Losses on derivatives were not offset by portfolio valuation gains.

Mortgage REIT book values were crushed. Mortgage REIT equities traded at discounts rarely seen. The Fed began to buy fixed rate agency MBS in earnest on Monday, March 23, but that was too late for a number of credit-oriented mortgage REITs that announced they could not make margin calls. That said, the massive size of the Fed intervention, together with the near exhaustion of selling of fixed rate agency MBS on the part of leveraged firms, has allowed for a more stable operating environment going forward for firms such as Capstead that are focused on agency MBS that were not severely damaged in March.

Regarding Capstead specifically, early in the quarter, we were executing on plans to increase portfolio leverage modestly in anticipation of raising common equity. Acquisitions exceeded runoff in January and February, and $13 million in common equity was issued in February, using our at-the-market continuous offering program. In early March, it became apparent that the markets were deteriorating, and our focus shifted to generating liquidity. Runoff from March was not replaced.

Swaps were paired out of and not replaced. Repo was rolled into April and beyond. ARM pricing held up fairly well through the middle of March, comparatively speaking, even as the more liquid in traffic fixed rate agency market was breaking down. With the markets continuing to deteriorate, culminating a non-agency business actually trading on Sunday, March 22, we concluded it was prudent to sell a portion of our portfolio to prepare for future projected liquidity needs. I want to emphasize that throughout this time, we've met all margin calls.

Looking forward, we have recovered a portion of the lag in ARM pricing relative to fixed rate MBS that was evident at quarter end, with book value estimated to be up 4% to 5% at this point. With this improvement in book value and having not replaced April portfolio runoff, our leverage currently is a comfortable 7.8:1, compared to 8.5:1 at quarter end. As we begin replacing May portfolio runoff, reinvestment returns are very attractive. And perhaps most importantly, our borrowing costs are down dramatically, with unhedged repo rates now typically between 20 and 35 basis points, thanks largely to the Fed having reduced the Fed funds rate at 150 basis points in March to near zero.

Wrapping up, we believe the worst of the recent market turbulence is behind us, and our portfolio is well-positioned to generate attractive returns on investment capital at lower leverage levels than we have employed in the recent past. Looking forward, we are increasingly confident that for the rest of the year, we can produce core earnings that will meet or exceed our current $0.15 a quarter common dividend run rate. With that, I'll turn the call over to Lance.

Lance Phillips -- Senior Vice President and Chief Financial Officer

Thank you, Phil. We reported a GAAP net loss of $204.7 million this quarter or $2.21 per diluted common share. Our core earnings were $19.8 million or $0.16 per diluted common share. Core earnings exclude realized and unrealized losses on our portfolio-related interest rate swap agreements, along with the realized loss on the sale of $2.5 billion of securities.

We include a reconciliation of GAAP and core earnings on Page 9 of our press release. Book value decreased $2.55 per share during the first quarter, ending at $6.07 per common share, primarily due to $1.84 in losses in our interest rate swap agreements, of which $1.04 were realized losses. Additionally, we incurred a realized loss of $0.70 on the sale of the securities. With the realized losses from hedging activities in 2019 and this quarter, it is expected that all 2020 common and preferred dividend distributions will be characterized as nontaxable return to capital.

Portfolio yields averaged 2.49% during the quarter, a decrease of 18 basis points from the 2.67% we reported in the prior quarter. Yields declined primarily due to lower cash yields as a portion of our ARM portfolio reset to lower prevailing interest rates and, to a lesser extent, as a result of an increase in our lifetime prepayment estimates. Our portfolio-related borrowing costs after adjusting for hedging activities averaged 1.72% during the first quarter, 25 basis points lower than in the prior quarter, leading to a 7-basis-point improvement in our net interest spreads. During the quarter, we paired out a $5.2 billion in swap agreements, replacing them with $2.2 billion in new swap agreements at lower rates.

The benefits of lower unhedged repo rates and lower fixed rates on our swap book were partially offset by the declines in receive leg of these derivatives based on lower three-month LIBOR and OIS rates. At March 31, the fixed pay rate on our swap book was 1.44%, a decline of 33 basis points from rates and effect on December 31. These lower fixed rates, together with lower notional balances, should benefit future earnings. With that, we will open the call up to questions.

Questions & Answers:


Operator

Thank you, sir. [Operator instructions] And the first question we have will come from Steve Delaney of JMP Securities. Please go ahead.

Steve Delaney -- JMP Securities -- Analyst

Good morning, everyone. I was wondering, a lot of moving pieces, and I think you guys sound like you're -- I know you were in the eye of the storm there in March, but glad to hear that things have kind of settled to where they are today, given the backdrop that we're all living in. Just curious, looking forward, Phil, you commented on the stability, the expected stability of the dividend. I'm just curious if -- how you guys see the range of levered returns on equity, if whether you were to go drop down to maybe seven times or move up to nine times.

What are we kind of looking like there? And part of that is -- obviously, entails something we don't know exactly, and that would be your hedging strategy. Thanks.

Phil Reinsch -- President and Chief Executive Officer

Yes. So as I mentioned, we are around 7.8:1 now after not replacing April runoff, and we're replacing May runoff. So you can kind of figure eight times is what we view as a reasonable --

Steve Delaney -- JMP Securities -- Analyst

Right.

Phil Reinsch -- President and Chief Executive Officer

And returns are going to be strong. We're exceeding -- well exceeding -- the platform, all-in, is well exceeding the terms -- the clock of our mezzanine capital, so it's boosting our common equity leverage from that.

Steve Delaney -- JMP Securities -- Analyst

Right.

Phil Reinsch -- President and Chief Executive Officer

And frankly, there's a heavier ratio of mezzanine to common equity than it was at one quarter ago with the --

Steve Delaney -- JMP Securities -- Analyst

That's true.

Phil Reinsch -- President and Chief Executive Officer

We experienced. So future returns look great. Now, at the margin we're reinvesting, we're looking at 12-plus-percent ROEs on new acquisitions, but the base portfolio is kicking out some really nice returns right now.

Steve Delaney -- JMP Securities -- Analyst

And on your prefs, is any fit that -- I could dig it out of the queue, but is there anything coming up that you might have a rate benefit on that, what are there, five-year fixed and fixed to floating? And there's a period in which you can call those, right, if anything is above market?

Phil Reinsch -- President and Chief Executive Officer

You're talking about our preferreds?

Steve Delaney -- JMP Securities -- Analyst

Oh, yeah, your preferreds, sorry.

Phil Reinsch -- President and Chief Executive Officer

Our Series E preferred is callable today, and it's got a 7.5 coupon. And our $100 million of unsecured borrowings or pref maturity can be --

Steve Delaney -- JMP Securities -- Analyst

It drops, yeah.

Phil Reinsch -- President and Chief Executive Officer

Given that, they're at a very decent floating rate over LIBOR that wouldn't be all --

Steve Delaney -- JMP Securities -- Analyst

Wouldn't add much. So the Series E might be an opportunity depending upon how the mortgage REIT equity markets settle down here over the next couple of quarters. OK. Well, thanks for the comments, folks, and you all be safe as Texas comes out of quarantine here in the weeks ahead.

Operator

And next, we have Eric Hagen of KBW.

Eric Hagen -- KBW -- Analyst

Hey, thanks. Good morning, guys. And my best wishes to you as well. One of your peers was just talking about some of the benefits of being able to fund off balance sheet with TBAs.

Just any thoughts on whether the moves from last quarter and the funding pressure that we saw just across the space, like you guys talked about in your opening remarks, just really just accelerates or move potentially into the fixed rate market just in order to access that off-balance sheet funding, which can be very valuable at certain points in the cycle. Thanks.

Phil Reinsch -- President and Chief Executive Officer

That's interesting when we view the retail market is behaving very nicely in here. We don't see availability of repo as a problem. The repo counterparties have had their book of businesses reduced significantly because of all the delevering that occurred in March. I might characterize them as having a -- being hungry for balances.

So they're not pushing back with any kind of higher haircuts or anything like that, and plenty of reasons for them not to push hard on rates. That said, you also got to look at financing with TBAs. You start to consider you're carrying all the great risk associated with that kind of a position, so you really are levering up with that. So I don't see any reason for us to be playing in the TBA market.

One thing we'd be taking 30-year fixed kind of exposure that's not really part of our strategy at this point.

Eric Hagen -- KBW -- Analyst

OK. And then, what prompted the sale in current reset ARMs versus longer reset? Can you just -- yeah, I feel like I ask this maybe once a year. Can you just give us a snapshot for the pricing spread that you expect in the current reset bucket versus longer reset bucket today?

Phil Reinsch -- President and Chief Executive Officer

Yeah. I'll let Robert speak to that.

Robert Spears -- Executive Vice President and Chief Investment Officer

Yeah, sure, Eric. Part of the decision, the reason we sold shorter reset securities was as simple as the larger buyers. If you wanted to do size this quarter, the larger buyers were looking for shorter reset paper. We sold a combination of pre-reset recently resetting ARMs, Ginnie Mae ARMs, etc., mainly because there was a decent demand for that at that point in time.

Having said that, looking at our remaining portfolio, it's still 41% shorter reset and 59% longer reset. And we expect that mix to -- it's not really outside of where we've been. It's kind of been 60-40 runway versus another. That was kind of it in a nutshell.

Guys were specifically looking for shorter reset paper.

Eric Hagen -- KBW -- Analyst

OK. And what do the prices look like in each of those buckets right now? Can you just give us a snapshot there? And then one on the hedging side while on that. Just the longer duration gap, was the reason for that on its -- the gap is going in a certain direction or some in that quarter balancing? I mean, what kind of duration do you guys feel comfortable running in this environment? And where is your duration concentrated on the yield curve? Thank you.

Robert Spears -- Executive Vice President and Chief Investment Officer

Sure. I mean, if you look at the performance over the quarter, shorter reset securities underperformed to some degree. They were down a point and a quarter to a point and a half in price. Our longer reset securities were up a point in price.

As Phil alluded to earlier, the post quarter end, you're seeing spreads recover nicely in both segments of our book. The duration gap, we took our gap out to six months, which in this environment with where the Fed is, we're very comfortable with that. And if you look at our remaining swap position of $4.4 billion, it essentially covers the bulk of our longer reset position, and we're more or less unhedged on our shorter resets. And so our exposure, given the coupon of our longer resets right now, really, we're still kind of looking in the two year in an area where we see risk on our longer reset book, probably inside of two years, actually, probably closer to year and a half.

And so we're mindful of that. And also, you have to keep in mind that ARMs underperformed. Fixed rate, because, basically, the Fed came in on the 23rd and they bought agency fixed rates, and if you look at the part of the agency market that they did not buy directly, it was basically ARMs and CMOs. And so now as you get over quarter end, fixed rates have risen so much that there's a really nice bid for ARMs predominantly from banks.

And so because of that, we feel like even if rates go up, the first 50-or-so basis points, spreads and ARMs have widened so much that there's probably not a lot of room for prices to slip. So we're comfortable running a little longer right now because spreads are wider, and we think in an up rate environment, those spreads would tighten back in. And so we don't have -- I mean, if you just look at where -- I mean, you got 30-year two and a halfs trading with a 104 handle right now, and we've got our entire ARM book marked with the 103 handle. And so if you just kind of interpolate where those prices would go if rates sell off, we think it makes sense to not hedge as much right now given where spreads are, and we're not of the mindset that the Fed is going to tighten anytime soon.

So we're probably going to run from the longer side in the next few months. And right now, we have closer to 50% of our liabilities hedged, and I think that's probably where we'll be for the next few months as opposed to -- prior to this, we had 70% of our liabilities hedged.

Eric Hagen -- KBW -- Analyst

Right. Thank you very much for that market call, guys. And stay well. Thank you very much.

Robert Spears -- Executive Vice President and Chief Investment Officer

Thank you.

Operator

And the next question we have will come from Derek Hewett of Bank of America.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

Good morning, everyone. And hopefully, everyone is doing well. I hopped on the call a little late, so I might have missed it. But could you remind us kind of what your near-term outlook is for prepayment speeds at this point given the low rate environment?

Robert Spears -- Executive Vice President and Chief Investment Officer

Sure. I'll take that. If you look at ARM securities right now, last month, generically, ARM speeds kicked up about 18% from the prior months, and fixed rates kicked up about 40%. And so I think generically, fixed rates were kind of in the mid-20s and ARMs were in the high 20s.

So you have conflicting stories right now, right? Rates are down, and so refinances should be up. And at the same time, between all the forbearance and the disarray in the primary mortgage market, we think speeds are going to be well contained in our book. And along with that, our current reset book, those loans will continue to reset down such that our shorter resets -- the gross WAC is going to reset down to around 3%, which with 30-year no-cost refinance rates closer to 3.5%, we think that's a very compelling speed story going forward. Most of the speed pressure in our book will be on our longer resets that are more newly originated in the last couple of years, and we'll have a slightly higher gross WAC.

So having said all that, putting the pieces together, we think speeds are going to be very well contained in the next few months. And probably, they're, obviously, going to be slower than what just generic interest rate forecast would have if you didn't take into account the virus and everything else, and so we really feel good about our speeds going forward over the next five or six months.

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

OK, great. Thank you.

Robert Spears -- Executive Vice President and Chief Investment Officer

Sure.

Operator

Well, sir, no further questions at this time. We're going to conclude today's question-and-answer session. I would now like to turn the conference call back over to Ms. Lindsey Crabbe for any closing remarks.

Ma'am?

Lindsey Crabbe -- Director of 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: 24 minutes

Call participants:

Lindsey Crabbe -- Director of Investor Relations

Phil Reinsch -- President and Chief Executive Officer

Lance Phillips -- Senior Vice President and Chief Financial Officer

Steve Delaney -- JMP Securities -- Analyst

Eric Hagen -- KBW -- Analyst

Robert Spears -- Executive Vice President and Chief Investment Officer

Derek Hewett -- Bank of America Merrill Lynch -- Analyst

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