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Arlington Asset Investment Corp (AAIC)
Q3Â 2020 Earnings Call
Nov 4, 2020, 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 2020 Earnings Call. [Operator Instructions] After the company's remarks, we will open the floor for questions. [Operator Instructions]
I would like to now turn the conference now over to Richard Konzmann. Mr. Konzmann, you may begin.
Richard Konzmann -- Executive Vice President, Chief Financial Officer and Treasurer
Thank you very much and good morning. This is 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 [Phonetic] 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 beliefs, 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 statement.
I would now like to turn the call over to Rock Tonkel for his remarks.
Rock Tonkel -- President and Chief Executive Officer
Thank you, Rich. Good morning, and welcome to the third quarter 2020 earnings call for Arlington Asset. Also joining me on the call today is John Murray, our Portfolio Manager. Continued federal monetary and fiscal support contributed to improved economic conditions and a risk on investor's sentiment during the quarter. Risk asset prices rallied with the equity markets continuing to strengthen and credit spreads on most fixed income asset classes tightening against the backdrop of muted interest rate volatility during the quarter.
With low interest rate volatility and ongoing Federal Reserve balance sheet support, agency mortgages performed well during the third quarter. With repo funding for Agency MBS readily available at attractive funding costs, investing in levered Agency MBS continues to be an appealing investment opportunity for the company. However, certain investment risks continue to exist, including the uncertain path of prepayments in the low rate environment, and higher pay of premiums embedded in the current pricing of specified pools.
Along with most fixed income products, mortgage credit asset values generally increased during the third quarter reflecting overall tightening of credit spreads with the improved economic outlook. Supported by favorable housing supply dynamics, low mortgage rates and stabilization of delinquencies, residential mortgage credit asset prices strengthened during the quarter. Commercial mortgage credit performance was mixed during the quarter as the economic impact of the pandemic has more adversely impacted certain commercial asset classes than others.
In the current environment, the company's focus is to grow earnings in the near-term and raise overall returns to shareholders over time through investments in Agency MBS, credit, and other financial asset classes which offer attractive returns today. In addition to securing multiple income sources which diversify risk and improve the level and reliability of returns, the company seeks to maintain a stable financial position by keeping leverage low and financial flexibility high, while using term non-margin financing structures were available to protect against higher interest rates and simultaneously permit underlying asset values to rise with lower rates.
Such a posture provides the company flexibility through volatile periods and the ability to be opportunistic and nimble in approaching potential investments. Further, the company is focused on creating asset partnerships or platforms, where possible to promote predictability of investment flows, growth and compounding value creation opportunities that layer on top of the current income returns embedded in the company's investments generally.
During the third quarter, Agency MBS and certain mortgage credit sector satisfied each of the company's portfolio objectives. However, as expected, future returns on some mortgage credit segments within the company's portfolio have tightened as a result of appreciation. The company is evaluating investment opportunities in MSR-related investments as well as real estate opportunities and other financial asset types, which may meet the company's objectives for low leverage, robust returns, diversification of risk as well as attractive financing structures.
Turning to the actual results for the quarter, the company reported GAAP net income of $0.12 per share and non-GAAP core operating income of $0.03 per share. The company's book value was $5.92 per share, as of September 30, a 5.2% improvement from last quarter as both its agency MBS and mortgage credit investment strategies experienced positive performance. The company maintained a low leverage profile with net repo financing to investable capital ratio at 1.5 to 1, as of September 30, and returned capital to shareholders through accretive stock repurchases during the third quarter at significant discounts to book value.
During the third quarter, the company repurchased 5.8% of its outstanding common stock at an average repurchase price of $2.80 per share. The company will evaluate future common stock dividends on a quarterly basis based on multiple factors, including opportunities to return capital to shareholders through accretive stock repurchases, overall economic and market conditions, available returns on new investments, ongoing liquidity needs and REIT distribution requirements. The company does not expect to have any further REIT distribution requirements for 2020.
The company was encouraged by the performance of both its Agency MBS and the mortgage credit investment portfolios during the third quarter, as both positions benefited from spread tightening and attractive investments made during the quarter, while continuing to operate with overall low leverage and financial flexibility. As of September 30, the company's investable capital was allocated 69% to its agency mortgage strategy and 31% to mortgage credit investments. Although, lower repo funding costs have benefited returns and levered agency MBS investments, bond prices continue to be relatively expensive due to the Federal Reserve's ongoing support through its substantial purchases of agency MBS.
Within its agency MBS investment portfolio, the company continues to decrease its allocation to higher coupon securities during the third quarter, and as elevated prepayment speed expectations have significantly diminished the return opportunities in this end of the coupon stack. The company currently sees greater return opportunities in the lower coupon agency mortgages with available levered returns in the high-single digits.
The company's mortgage credit investments currently consists of a diversified portfolio of financings, collateral -- collateralized by mortgage servicing rights, business purpose residential mortgage loans, commercial mortgage loans and residential mortgage loans. Here the company is actively pursuing investment opportunities across various asset classes that it believes will generate high risk adjusted returns with the potential for greater value creation for shareholders overtime. The company continues to see attractive return opportunities in the mortgage servicing rights sector.
Current purchase price multiples for mortgage servicing rights are attractive as the company believes the future performance of MSRs will exceed the implied prepayment expectations and the anticipated service or advance requirements embedded in current MSR values, while also offering appreciation potential, associated with any further retracement back toward pre-COVID MSR multiple levels.
Although credit spreads on financing and mortgage servicing rights tightened during the third quarter along with other fixed-income assets, the company continues to see opportunities in MSR financing investments as well. However, in the MSR asset class, the company sees higher risk adjusted returns by investing directly in mortgage servicing rights and the company made progress during the quarter toward a partnership that could lead to direct economic investments in MSRs with positive implications for returns on MSR investments and overall company returns going forward.
During the quarter, business purpose residential loans offered particularly attractive risk-adjusted returns. Business purpose residential mortgage loans are low LTV loans to professional real estate investors that are secured by a first-lien position on non-owner occupied residential real estate that generally requires construction, repair or rehabilitation. During the third quarter, the company added to its business purpose loan portfolio with a first loss piece of a newly issued securitization for $11 million with an expected loss adjusted return on capital in the mid-teens.
As a result of the company's loss mitigation rights on the underlying loan collateral and option to purchase any significant -- any delinquent loans from the trust, the company consolidates for financial reporting purposes, the underlying mortgage loan collateral and term notes issued by the trust. However, the term notes issued by the trust have recourse only to the loan collateral of the trust with no economic recourse to the company.
The company does not currently have significant repo funding exposure in its mortgage credit investment portfolio, as of September 30, the company did not have outstanding repo funding on any of its non-agency MBS or MSR financing investments. The company's sole funding exposure on its mortgage credit investment portfolio consists of a $32 million repo funding or a commercial mortgage loan with strong credit statistics that has performed better than expected at origination, as a repo funding maturity in August of '21 and has had no margin cost to date.
Going forward, the company will continue to limit its use of margin of repo funding for mortgage credit investments, instead, the company will focus on financing mortgage credit investments either directly or indirectly, through long term and non-marginal financing structures. The company has made solid progress toward establishing a portfolio, comprised of multiple financial asset channels to provide diversification of risk and multiple income sources to raise overall returns to shareholders. We expect to maintain a strong financial position highlighted by low leverage, high financial flexibility and the use of term financing structures where possible.
In addition to its existing Agency MBS and mortgage credit strategy, the company continues to evaluate additional mortgage credit, real estate and other investment opportunities with a focus on developing investment platforms and strategic partners where possible that will result in longer-term enterprise value creation and provide a compounding opportunity that complements the current income embedded in the bulk of the company's investments. This should enable the company to deliver a positive economic return to shareholders in the near-term, while retaining sufficient liquidity to be opportunistic and capture attractive investment opportunities that may arise across sectors as economic conditions evolve over coming quarters.
Operator, I would now like to open the call for questions.
Questions and Answers:
Operator
Thank you. At this time, we will open the floor for questions. [Operator Instructions] Our first question will come from Doug Harter with Credit Suisse.
Josh Bolton -- Credit Suisse -- Analyst
Hey, guys. This is Josh, on for Doug.
Rock Tonkel -- President and Chief Executive Officer
Hi, Josh.
Josh Bolton -- Credit Suisse -- Analyst
Hey, Rock. How are you doing? We saw the buyback activity during the quarter, I was wondering if you could talk a little bit about how you're thinking about the attractiveness of buyback versus paying out a dividend? And then when we think about the expense base for the company, can expense reduction keep up with an accelerated share buyback or how should we think about expenses as a percentage of equity going forwards? Thanks.
Rock Tonkel -- President and Chief Executive Officer
Great. Thanks, Josh. So I think, with the stock in the neighborhood of recent prices, it seems pretty clear to us that buyback is a more compelling opportunity than dividending at this stage, particularly given that we don't have a distribution requirement for the remainder of the year. So, from a shareholder value creation standpoint, it seems to us that the better path is the repurchase versus the dividend. And that's why you've seen ongoing stream of repurchases over the last couple of quarters. And we have the benefit of, as I've said, a stable financial position with strong liquidity and flexibility in the balance sheet to be able to do that.
As to the expense base, I'd say, look, there are some constraints there and how fast the expense line can come down, but we've made good progress in reducing the expense line. And I think that there is room for more of that to occur in the next year -- over the course of this year and in the next year and through next year. So I think that there are further opportunities for reductions on the cost side. Whether those keep up, or don't exactly keep up with the pace of buybacks, will be dependent on what the market does with the stock.
And so at the pace that we've been on, I think expense reductions can reasonably keep pace with that sort of type activity, but to the extent there is an acceleration there that may be more challenging except over the longer term. But I do see the possibility of further expense reductions over the next 12 months. That will be helpful in reducing the burden on the capital and improving returns to shareholders by so doing.
Josh Bolton -- Credit Suisse -- Analyst
Great. Makes sense. And then any update on how book value is trending so far in the fourth quarter? Thank you.
Rock Tonkel -- President and Chief Executive Officer
I'd say so far book value is up by a point or two. We've had a couple of spots of good performance in the portfolio and some other factors that have been helpful in pushing the book value up somewhat during the course of October.
Josh Bolton -- Credit Suisse -- Analyst
Great. Thanks, Rock.
Operator
Thank you. Our next question will come from Jason Stewart with Jones Trading.
Rock Tonkel -- President and Chief Executive Officer
Hi, Jason.
Jason Stewart -- Jones Trading -- Analyst
Hi. Good morning, Rock. Thanks for the question. On the agency side, I was wondering if you could give a little bit of commentary with regards to the origination environment. How you think that plays out with regard to spec pool pay ups, as we go through this seasonally slow period of time?
Rock Tonkel -- President and Chief Executive Officer
Great. Thanks. I'd say, we continue to be pretty significantly invested on the spec pool side for a pretty obvious reasons, the protection from the prepayment speeds, which have been volatile and I don't think we really expect them to -- the pattern of them to change materially. We would expect them to remain relatively high and a bit uncertain. So on the one hand we like the protection offered by the spec pools, but at the margin they have gotten to be quite expensive, and so I wouldn't be surprised if you see us be a little bit more active on the role in the fourth quarter, they -- may be than we were proportionately in the third quarter. And so I think it wouldn't surprise me, if between now and the end of the quarter, depending on how our role plays out for the rest of the year, if we were to be in the end more active on the roll side, proportionately, the portfolio and may be at the margin de-emphasize the spec side just a touch here in these conditions.
Jason Stewart -- Jones Trading -- Analyst
Great. That's helpful. Thank you. And on the credit portfolio, how much does HPA play into the thesis on the credit side?
Rock Tonkel -- President and Chief Executive Officer
We're really not relying on the HPA side, terribly notch, I'd say -- if it has any involvement in that equation, it's modest. We feel like the credit investments we've made to-date stand on their own 2 feet based on where HPA -- where housing prices are today, to the extent we continue to see some appreciation grade. We'll get more protection in those assets to the extent that we're reviewing other real estate opportunities.
As I mentioned in the script, then that HPA factor will come a bit more into play. So for example, we have spent a lot of time over the last months taking a hard look at single-family rentals. That segment seems to have some compelling characteristics to it, both from a carry return, but also a total return characteristic including HPA to your point. And so, in that calculation we would expect there to be either very little or modest depreciation that really isn't the driver for our investment thesis in the single-family rental, if we were to enter that space.
But we do feel like those returns have become more compelling. I mean, we're not alone, I don't think. But we feel like those returns have become more compelling relative to some other alternatives as spreads have tightened on QSub securities and rates have remained very low. So absolute returns are more modest and therefore I think single family rental and MSRs for that matter stand out as having sort of out distance return potential in this environment.
Jason Stewart -- Jones Trading -- Analyst
Right. I'll jump out after this last question. On the MSR side have you -- can you share any details on how you think about recaptures when you enter these agreements on the MSR side. With rates where they are, it seems to be that's one of the driving forces of returns is how much you can negotiate on the recapture side?
Rock Tonkel -- President and Chief Executive Officer
It's a very important aspect of it and to the extent that as I said in the script, we've made progress on a potential partnership in that regard and that partner -- we'd be working very closely with that partner to maximize the recapture on that portfolio.
Jason Stewart -- Jones Trading -- Analyst
Okay. Thank you for the questions. Appreciate it.
Rock Tonkel -- President and Chief Executive Officer
You bet. Thank you, Jason.
Operator
Thank you. Our next question will come from Christopher Nolan with Ladenburg Thalmann.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Hey, guys. Rock, is the...
Rock Tonkel -- President and Chief Executive Officer
Hi, Chris.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Fourth quarter to-date is the investment mix in terms of capital allocation sort of staying weighted toward the agency investments?
Rock Tonkel -- President and Chief Executive Officer
I'd say in the fourth quarter so far it's probably not much different than when we stated in the script. I think in the script, we said it was about two-thirds, one-third, and I'd say it's not terribly different at this stage versus that stage.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Okay. And then, I guess the lower CPRs in the quarter, is that simply just a function of going to lower coupon agency RMBS?
Rock Tonkel -- President and Chief Executive Officer
Yes. Exactly.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Great. And then, I noticed that the debt amount have, the traditional metrics you guys provide like net interest margin, funding cost and all that stuff. So in the future times, if you guys can consider putting those back, that'd be great.
Richard Konzmann -- Executive Vice President, Chief Financial Officer and Treasurer
And a lot of those will be in the 10-Q as well.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Understood. But it's helpful before the call to have that stuff handy. Final question, Rock, just a clarification on outlook for a leverage. It seems to me that you're indicating that you're going to keep the leverage levels, relatively low, below 2 times, but did I hear you correctly, or do I misinterpret that?
Rock Tonkel -- President and Chief Executive Officer
Yeah. I don't -- I think generally you heard me correctly. I don't put a particular hard number on it, Chris. But I think just as we saw slight migration from the third -- from the second quarter to third quarter, we may see a slight migration. But generally, as I've said repeatedly through the script, from our perspective, paramount to maintain a low leverage and high financial flexibility in the balance sheet and we will continue to seek to do that. So I think that means there may be some modest expansion in leverage, but I don't expect it to be substantial.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
All right. Okay. That's it from me. Thank you.
Rock Tonkel -- President and Chief Executive Officer
And to the point I made in the script, we're seeking to use structural leverage where possible versus repo leverage and so we would first be -- if we were increasing leverage, it would first be done through that feature versus repo, if that were at all achievable.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Yeah. No. I think that echoes what you've said in the past quarters for this current strategy on the mortgage credits.
Rock Tonkel -- President and Chief Executive Officer
Yeah.
Christopher Nolan -- Ladenburg Thalmann -- Analyst
Thank you.
Rock Tonkel -- President and Chief Executive Officer
Thank you.
Operator
Mr. Konzmann, at this time, there are no more questions.
Richard Konzmann -- Executive Vice President, Chief Financial Officer and Treasurer
Okay. Well, thank you very much everyone. We appreciate it and if you have any follow-on, please reach out. Thank you very much. Have a good day.
Duration: 24 minutes
Call participants:
Richard Konzmann -- Executive Vice President, Chief Financial Officer and Treasurer
Rock Tonkel -- President and Chief Executive Officer
Josh Bolton -- Credit Suisse -- Analyst
Jason Stewart -- Jones Trading -- Analyst
Christopher Nolan -- Ladenburg Thalmann -- Analyst
