Arlington Asset Investment Corp (AAIC) Q1 2021 Earnings Call Transcript

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Arlington Asset Investment Corp (NYSE: AAIC)
Q1 2021 Earnings Call
May 6, 2021, 12:00 p.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 First Quarter 2021 Earnings Call. [Operator Instructions] I would now like to turn the conference over to Rich 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 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 statements.

I would now like to turn the call over to Rock Tonkel for his remarks.

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Thank you, Rich. Good afternoon, and welcome to the first quarter 2021 earnings call for Arlington Asset. Also joining us on the call today is John Murray, our Portfolio Manager. During the first quarter, risk assets continue to rise amid a progressing global economic recovery, supported by government monetary and fiscal stimulus policies, broader vaccine rollout efforts and growing expectations of a full economic reopening. With the increased positive outlook, the overriding long-term economic theme for the quarter was inflation risk. In response, the long-term interest rates rapidly rose with the 10-year U.S.

Treasury rate increasing over 80 basis points during the first quarter, leading to a significant steepening of the yield curve as short interest rates remain anchored at historical low levels. The short rise -- the sharp rise in the long end of the treasury curve led to an extension of mortgage durations, particularly lower coupon agency MBS. Performance of mortgage servicing rights was strong during the first quarter as prepayment speed expectations declined with the rise of mortgage rates. Residential mortgage credit spreads were relatively flat during the quarter, while home price appreciation continued its strong annual growth.

The company's long-term investment strategy is to construct an investment portfolio with multiple sources of income, which complement our Agency MBS portfolio, diversify risk and improve the level and reliability of returns. Over time, the company expects to complement its allocation of capital and agency mortgages by deploying portions of its liquidity, currently in the form of unencumbered agency MBS into its other targeted investment strategies, including mortgage servicing rights, mortgage credit, and other asset classes. We expect to maintain a strong, stable and liquid financial position by keeping leverage low and financial flexibility high, while utilizing term non-margin financing structures where available.

In addition, the company is focused on creating partnerships or platforms where possible, to promote the predictability of investment flows, growth and the potential for compounding value creation opportunities that layer on top of the current investment returns embedded in the company's investments. During the first quarter, the company made solid progress toward these goals by reallocating capital into MSR-related investments. As of March 31, the company's investable capital was allocated 75% to its agency mortgage strategy, 12% to mortgage servicing rights and 13% to mortgage credit. Newly created mortgage servicing rights of Fannie Mae and Freddie Mac loans currently offer attractive return opportunities.

At purchase price multiples of just above four times, unlevered MSR investments offer comparable base returns to levered agency MBS with potential upside from multiple expansion, positive correlation to duration extension, no mark-to-market financing risk and no exposure to matched hedge funding risk. Significant barriers to entry exist for investing in mortgage servicing rights as an investor is required to hold specific licenses to purchase or hold MSRs directly. To invest in MSRs through traditional means, an investor would typically need to establish or acquire a licensed residential mortgage servicer, which requires a significant amount of time and capital to complete as well as subjects the investor to ongoing operational and regulatory oversight and risk.

On our prior earnings call, we highlighted that the company has established a strategic relationship with a licensed GSE-approved servicer that enables the company to garner the economic return of an investment in mortgage servicing rights without holding the requisite license directly. Under the terms of our partnership, the company provides capital to our partner to purchase MSRs directly. And the company, in turn, receives all the economics of the MSRs, less a fee payable to our partner. We believe this efficient, cost-effective and lower risk channel for investing in the economics of mortgage servicing rights differentiates Arlington.

To date, our economic thesis for allocating capital to mortgage servicing rights has produced positive results as our MSR-related asset investment portfolio generated outsized returns above expectations during the first quarter. MSR cash flows performed as expected, and the portfolio experienced significant multiple expansion from approximately three times to modestly above four times. The company has not utilized any leverage on its MSR investment portfolio to date, but at our option and direction, our partner has the capacity to add leverage to increase potential returns. The company's MSR investment portfolio grew to $36 million or 12% of investable capital as of quarter end.

And subsequent to March 31, we have invested an additional $31 million in MSR-related assets, increasing our investable capital allocation to over 20% today, representing approximately $6.4 billion of unpaid principal balance. Turning to levered agency MBS. Returns there continue to benefit from low repo funding costs, ongoing federal reserve support and steepening yield curve. Although the rise in long-term interest rates and extension of mortgage duration have increased hedging costs during the quarter. Against this backdrop, we are currently seeing available returns in the high single digits in levered agency MBS with an appropriate hedge position.

However, if the economy continues to demonstrate improvement and inflation concerns continue to escalate, market expectation that the Federal Reserve may taper its holdings of agency mortgage could lead to a widening of agency mortgage spreads. With mortgage spreads currently at multiyear tight, the company remains cautious about significantly increasing the leverage on its allocated agency mortgage capital. Taken in combination, complementing the levered agency portfolio with MSRs decreases overall risk while increasing ROEs. MSRs tend to increase in value as mortgage rates rise and more specifically when durations on agency MBS extend.

This increase in value resulting from mortgage extension typically occurs when mismatches between levered agency MBS and hedges are highest. Furthermore, MSRs are a positive carry hedge for levered agency securities, replacing negative carry swaps with positive carry MSRs, turns the largest drag unlevered agency MBS returns in the current environment into a carry positive. More specifically, for every $10 million in MSRs we aggregate, we can invest approximately $5 million of capital in leveraged agency securities without the need for a long-dated hedge.

Said another way, set against the backdrop of our agency MBS portfolio balance of approximately $615 million at March 31, the MSR portfolio we now hold with unpaid principal balance of $6.4 billion, $67 million of capital invested and a WACC of 2.96%, would have eliminated the need for approximately $120 million of long-dated hedges at that time, which would have added approximately 200 to 400 basis points of ROE to fully levered agency MBS returns, boosting them into the double digits from the high single digits and improving the overall risk profile in that portfolio combined.

In the current environment, the company expects to maintain a substantial capital allocation to agency MBS, while evaluating opportunities to redeploy the liquidity it holds primarily in the form of unencumbered agency MBS and into other investments in its targeted strategies over time that complement agency MBS, while offering better risk-adjusted returns and requiring lower at-risk leverage. The company is presently focused, in particular, on continuing to invest in MSR-related assets as well as mortgage credit opportunities, which offer risk-adjusted returns in excess of agency MBS, while also closely evaluating opportunities in other financial asset classes, including those that may not be mortgage or real estate-related that meets the company's objectives for low leverage, strong returns, diversification of risk and term or non-marginable financing structures.

For the first quarter, Arlington's agency mortgage investment portfolio with a concentration in lower coupon securities underperformed as asset prices declined due to increased rate volatility and asset duration extending in response to the sharp rise in long-term interest rates. The company was net long duration and its combined agency MBS and hedge portfolio at year-end, while the MSR portfolio was not yet able to be scaled at the beginning of the year to fully offset agency MBS price decline. The company added significantly to its hedge and MSR positions as interest rates first began their rise, which served to mitigate the asset price declines experienced during the quarter. The underperformance of the company's agency MBS and hedge portfolio during the first quarter was partially offset by a very strong performance in the company's MSR-related assets as well as its mortgage credit investments due to strengthening credit metrics in that portfolio.

These combined investment portfolio performance results led the company to report book value of $6.12 per share as of March 31, a decline of three% from the prior quarter end. As of March -- as of April 30, the company's book value per share increased approximately one% since quarter end. The company continue to operate with low leverage and significant financial flexibility with its overall at-risk leverage ratio standing at 1.4:1 as of March 31, a decline of one turn from year-end. For the first quarter, the company reported a GAAP net loss of $0.20 per share and core operating income of $0.03 per share. As we highlighted during our prior quarter earnings call, despite the strong credit performance of a consolidated trust of residential business purpose loans, we anticipated its contribution to our first quarter core operating income would decline due to the short duration and accelerated paydown of that investment.

Although its contribution to core operating income was lower this quarter, the company's investment in this consolidated trust experienced a particularly strong economic return of 9% for the first quarter as its credit performance continue to exceed our initial expectations. The company did not declare a dividend on its common stock for the first quarter. The company's Board of Directors will continue to evaluate the payment of quarterly dividends on its common stock based on multiple factors, which -- including current earnings results, overall market conditions, liquidity needs, return opportunities on investments and REIT distribution requirements.

With regard to its REIT requirements, the company does have the flexibility to utilize its tax loss carryforwards to reduce its taxable income and annual distribution requirements. The company will also look to continue to return capital to shareholders by opportunistically repurchasing shares of its common stock at accretive prices. The company continues to have a large remaining authorization from its Board to repurchase shares of its common stock. Overall, the company is very encouraged by the solid progress it has made to date in a transition toward its long-term goals and is optimistic about its prospects going forward. The company took positive steps during the first quarter toward its objective of complementing its agency MBS portfolio with high-return non-commodity investment channels, which provide diversification of risk, multiple income sources to raise overall returns to shareholders and offer sustainable ongoing investment flow.

In addition to its existing MBS, MSR and mortgage credit strategies, the company continues to evaluate opportunities in other attractive financial asset classes with a focus on developing investment platforms and strategic partnerships that could potentially result in long-term enterprise value creation. As the company deploys available capital to MSRs and our diversified investments made through non-commodity channels, we expect higher returns from these investments to provide expanded earnings power over time, which can form the potential pathway for returning capital to shareholders.

As that deployment process occurs, we expect to maintain a strong financial position, highlighted by low leverage, high financial flexibility and the use of term financing structures where possible, enabling the company to be opportunistic and capture attractive investment opportunities that may arise across sectors as economic conditions evolve as well as the ongoing ability to utilize its sizable stock repurchase authority.

Operator, I would now like to open the call for questions.

Questions and Answers:

Operator

Thank you. [Operator Instructions] We'll take our first question from Trevor Cranston with JMP Securities.

Trevor Cranston -- JMP Securities -- Analyst

Hi. Thanks. A couple of questions on the MSR investments. I guess, first, as you think about deploying more capital into that asset class and the sort of benefits it has relative to an agency portfolio, I mean, how are you guys thinking about sort of a target for capital allocation? And how much of your capital you could potentially allocate toward MSRs over the course of the year?

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Good afternoon, Trevor. So today, with $67 million of capital invested there, we have not yet utilized the financing facilities that are available to us. And those financing facilities enable us to borrow not quite, but almost on a one-to-one basis. I don't think we envision that we would lever that significantly. But I think we could see our way to using something along the lines of half of that leverage amount, which on the existing capital allocation would take us up to the neighborhood of not quite $100 million of total value invested in MSRs.

So in the near term, that sort of feels like our horizon, our natural horizon. Depending on markets, multiples, primary rate and other factors, we would consider going beyond that, but our near-term horizon is probably somewhere between here and $100 million of total investment, which would mean a modest, if any, incremental allocation of capital now. That may change over time, but in the reasonable near-term time frame, that's sort of how we think about it.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Got it. And then in terms of the asset yield on MSRs, the number you reported on Slide 10 is pretty attractive relative to a lot of other fixed income assets in the market right now. I was curious is that nine-plus percent yield, is that something that particularly benefited from buying low coupons prior to the big increase in mortgage rates? And I was also curious if you could just comment on where you would expect economic yields on new MSR purchases today to be?

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Sure. So as you saw last quarter, we had initiated the partnership, during the course of the fourth quarter, I think probably in the latter part of the fourth quarter. And we had layered in, at that time, $10 million or $15 million or something like that of MSRs. We added another significant amount early in the first quarter. So we sort of got the benefit of investing in those at lower multiples, say, in the neighborhood of -- three-ish, maybe a little below, a little above, between those two baskets. A little bit below or a little above 3. And so we benefited during the quarter for multiple expansion, as I said in the script.

And to your question, yields were naturally higher there because of the lower multiple that we were paying on those MSRs.

Today, as I said, sort of -- I alluded to in the script, we look at multiples in the neighborhood of four. And at that level, you're probably closer to something like an eight. Maybe an eight and change, something like that would be a reasonable level on a bulk purchase and maybe a little higher on a flow. We would expect to be involved a little bit more going forward than we have been to date in the flow market, where those -- even at these multiples look like they're closer to nine. And so we feel like that eight to nine range today, depending on bulk or flow is probably a fair range for unlevered yield in those assets newly placed in the portfolio from here forward.

Trevor Cranston -- JMP Securities -- Analyst

Okay. Got it. And then in terms of your interest rate positioning of the balance sheet in the portfolio, looking at Slide nine, it seems like you have a fairly large amount of long-duration swaps relative to the agency book. And then in addition, you obviously have the MSRs and have continued to add to those.

Can you say what kind of -- what's your overall net duration is? Or your exposure to kind of changes in the long end of the yield curve? And also maybe comment on whether or not you've made any changes to the swap book in the second quarter as you continue to find more MSRs.

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Yes. Great question, Trevor. Great question. Well placed. The -- at that time, we had not yet closed on a block of MSRs that we've been able to put in place in April. And so no surprise to your question, that's provided an opportunity to sort of shift our footprint a bit from a duration perspective. So you see in the charts there that we had a bit of a negative duration bias, a negative duration bias at that time. And that's left now. That's closer to flat. I'd say still slightly negative, but meaningfully less negative duration than was the case at that time, but still between 0 and one. Also keep in mind that at the time you see those charts, neighborhood of $200 million of those were short swaps, two to three years.

And so that's worth keeping in mind. And then the last thing is we've actually scaled the agency balance up a bit more since quarter end with the benefit of that MSR block in place that closed in April. So we've got a bit larger agency book. We've obviously got a larger MSR footprint than we did at quarter end. And the net duration of that -- the net duration effect of all of that in combination with some modest shifts on the hedging side leaves us to a less negative duration more between 0 and one today than was the case then.

Trevor Cranston -- JMP Securities -- Analyst

Okay.

Richard Konzmann -- Executive Vice President, Chief Financial Officer and Treasurer

And Trevor, this is Rich. If you didn't see on Slide 19, we have the calculation at quarter end, our duration gap and the interest rate sensitivity, the rate shock sensitivity to the portfolio as well.

Trevor Cranston -- JMP Securities -- Analyst

Okay. I had actually missed that. So thanks for pointing that out.

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

So Trevor, was that clear, Trevor? Does that clarify it? Or is there more that would be helpful there?

Trevor Cranston -- JMP Securities -- Analyst

No, that did answer the question. Great. Appreciated the comment. Thank you, guys.

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

[Indecipherable]

Operator

We'll take our next question from Christopher Nolan with Ladenburg Thalmann.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Rock, in the second quarter, have you guys increased your capital allocation at all to mortgage credits?

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Slightly. I think we have begun to see more interesting opportunities, Chris, in mortgage credit in the second quarter, sort of very late in the first quarter, into the second quarter. So we've added a bit to that portfolio since the end of the quarter, and we are looking more closely at those as net ROEs have edged back up into the double digits from their types, which would have been high single digits. Some returns on equity and credit even got to the point where they were not that far above five.

And that has now loosened up and given us some new opportunities. We were selling into those types. As you saw our balances come down in the first quarter. Second quarter, we've actually been able to move that up a little bit. And without predicting that we will, it wouldn't surprise me if we were able to add some incremental volume there to the mortgage credit portfolio in the quarter, given the improvement in ROEs into the double digits.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

And as you look at the second half of the year, where, conceptually, are you thinking you would like the capital allocation division to look like from where it is now?

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Well, it's a good question. It will depend on relative risk-adjusted return opportunities. So as we've said now for a couple of quarters, we have been evaluating a number of opportunities across mortgage-related and some nonmortgage-related asset classes. We've made some progress there. I think I may have alluded in the last quarter, we were close on another one that in the end didn't work out, but we have several other initiatives that we are in process of that we're making solid progress on. We'd be hopeful that we'll have positive things to say about them this -- during the course of this quarter -- at our next quarter release. But we certainly can't guarantee that, but we are encouraged by progress in those things.

I think it'll -- that capital allocation mix will be a byproduct of the progress that we make in some of these alternative higher return risk diversifying asset opportunities that we are investigating now. For now, to my answer to Trevor's question earlier, I think you'll see us incrementally dial up the capital allocation to MSRs. I don't expect that, that -- in this particular quarter would be a really enormously substantial move up in the allocation to MSRs relative to agencies because we would most likely use some leverage in that portfolio as our first lever.

But that will depend on where multiples are and WACCs on MSRs versus levered returns in agency. To the extent that some of these others develop then in the quarter, the course of the second and the third quarter, through the year, then we'd expect to see that allocation rise above a total of 25%, which was where it was at the end of the quarter to non-agency MBS capital. So moving agency capital probably in that case, closer to 50% from the 75% today and in the process, raising returns and lowering leverage.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

My final question is for the mortgages underlying your MSRs, do you seek out a particular profile of the loan or borrower? And if so, what is that, please?

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Well, you can see from what I said in the script with a 2.96% WACC, we're trying to be quite focused. We're trying to be quite focused on keeping the lid on the WACC and protecting against prepayment speed escalation as best we can in that process. We're probably sitting here today at a little -- in the neighborhood of 50 basis points, I think, above our lows, our historic lows in the primary rate. And we feel like a 2.96% WACC, we're reasonably well protected. And we'll continue to try to focus on keeping those WACCs low in our ongoing MSR flow and bulk transactions. In the meantime, we're very, very focused on the nature of the originator.

The pattern of their prepayment experience across their assets, which we're also able to follow through our agency mortgage investing. So we're familiar with these originators, pretty intimately familiar with them, and we can -- we're aligning our MSR purchase investments with our knowledge from the agency side from a prepayment perspective, and we're very focused on the recapture capability of these of these originators and servicers to recapture the prepays. So that's our focus. We've had some success here initially. We feel like we'll continue to try to keep the discipline that we've begun as we've entered into this partnership and begun to scale it to some level of critical size relative to our total capital mix.

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Great. Thank you.

Operator

We'll take our next question from Josh Bolton with Credit Suisse.

Josh Bolton -- Credit Suisse -- Analyst

Hey. Thanks. Rock, you mentioned in your prepared remarks the share repurchase authorization that you guys have. Curious how you're thinking about the trade-off between deploying capital into one of your target assets versus the returns you would get by repurchasing shares? Thanks.

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Sure. So naturally, Josh -- good question, naturally, one that we're focused on every single day, as we evaluate alternatives. I think you know what the variables are, I think, pretty well in that, it is the magnitude of return on our opportunities versus the accretion that we can generate from repurchasing the stock, which is, on the one hand, substantial. But on the other hand, repurchasing the stock and reducing the capital base does have other effects, as you know, so that's an ongoing calculation.

You've seen us be quite aggressive in the past both corporately and personally, as folks saw in addition to buying back a healthy chunk of the stock last year at attractive prices and doing it accretively. I doubled my own personal stake in the company and other management members have as well. So we continue to view the stock as very positively from an investment perspective and our dynamic process for evaluating returns against that sets up in a context where we're also judging it against market volatility in the first quarter.

We did buy stock, not as much as we had in prior periods, and part of the reason for that was the level of volatility in markets as well as the very compelling nature of the quite exceptional return opportunity we felt we were facing in MSRs in particular. We're -- we continue to evaluate that all the time. We view the stock as very attractive today from an investment and repurchase perspective. And when our windows open up, you could assume that we will be very closely assessing that question on a day-by-day basis.

Josh Bolton -- Credit Suisse -- Analyst

Great. Thanks for [Indecipherable].

Operator

We'll take our next question from Jason Stewart with Jones Trading.

Jason Stewart -- JonesTrading -- Analyst

[Indecipherable]. Thank you. Rock, I was hoping you could elaborate a little bit more on your comment about non-mortgage, non-real estate opportunities. If it's -- how close we are to that? And sort of what realm of parameters you're looking at there? Thanks.

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

So a good question, Jason. I think we've alluded to this in the past that within the company, we have a range of intellectual property and expertise based on our collective many decades in financial asset classes, particularly related to housing and other credit but also in other areas. And so we evaluate those opportunistically on the basis of their sort of proprietary nature and their -- and our ability to create a sort of partnership or sort of strategic-type relationship there where we can generate not only a solid flow of high-return asset opportunities, but also compounding opportunity and value creation through upside, compounding through upside value and appreciation.

And so those are part of the metrics. I'd say we're making good progress on some of those. We don't have anything further to say about it right at the moment. But we're hopeful that during the second quarter, we may have the ability to speak more about that sometime between now and our next release or at our next release.

Jason Stewart -- JonesTrading -- Analyst

Okay. Thanks, appreciated all [Indecipherable] questions were already tackled. Thank you.

Operator

Mr. Tonkel, there are no more questions at this time.

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Well, thank you, everyone, very much. We appreciate your time, and happy to help offline, if that's helpful. Feel free to give us a call. Thank you.

Operator

[Operator Closing Remarks]

Duration: 36 minutes

Call participants:

Richard Konzmann -- Executive Vice President, Chief Financial Officer and Treasurer

J. Rock Tonkel, Jr. -- President and Chief Executive Officer

Trevor Cranston -- JMP Securities -- Analyst

Christopher Nolan -- Ladenburg Thalmann -- Analyst

Josh Bolton -- Credit Suisse -- Analyst

Jason Stewart -- JonesTrading -- Analyst

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