May 3, 2013
Executives
Robert E. Cauley – Chairman, President and Chief Executive Officer G.
Hunter Haas, IV – Chief Financial Officer and Chief Investment Officer and Director
Analysts
David Walrod – Ladenburg Thalmann Terry Mcevoy – Oppenheimer & Co.
Operator
Good morning and welcome to the First Quarter 2013 Earnings Conference Call for Orchid Island Capital Incorporated. This call is being recorded today Friday May 3, 2013.
At this time, the company would like to remind the listeners that statements made during today’s conference call, relating to matters that are not historical facts are forward-looking statements subject to safe-harbor provisions on the Private Securities Litigation Reform Act of 1995. This is now cautioned that such forward-looking statements are based on information currently available on the management's good faith belief with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements.
Important factors that could cause such differences are described in the company’s filings with the Securities and Exchange Commission, including the company’s most recent Annual Report on Form 10-K. The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.
Now I would like to turn the conference over to the company’s Chairman and Chief Executive Officer, Mr. Robert Cauley.
Please go ahead sir.
Robert E. Cauley
Thank you, operator. Good morning and thank you for taking the time to join us this morning.
With me this morning is Hunter Haas, the Chief Investment Officer and Chief Financial Officer. I would like to advise our listeners that we will be happy to answer any number of questions you might have regarding our results of operations in the Q&A session at the end of my prepared remarks.
I would like to take a few moment to talk about market developments over the quarter and then spend some time discussing this press release taking with the portfolio not just with regard to deploying the capital raised in IPO but also in reaction to market developments and how we are positioned going forward. I will conclude my prepared remarks with some comments on our earnings for the quarter.
The agency MBS market was impacted late in the third quarter of 2012 when the Federal Reserve announced the third round of quantitative easing or QE3. The Federal Reserve began purchasing $40 billion per month of Agency MBS plus reinvested pay downs on their existing Agency MBS portfolio back into additional Agency MBS.
The program is expected to remain in place until economic activity specifically the level of appointment improves. During the fourth quarter of 2012, Agency NBS prices slowed off slightly after the initial spike upwards in price in late September.
This trend continued into the first quarter of 2013 as economic data improved interest rates climbed in early March. However, this trend reversed mid March and NBS prices have rebounded into April.
Third year currently planned mortgages, currently trade at approximately the same level we handed last year. Economic data has turned soft again and coupled with re-emergence of troubles in Europe has led interest rates on U.S.
Treasuries back towards the levels at year-end as well. On April 11, 2013 the FHFA extended the exploration of HARP II for two years until December 31, 2015.
In the current market refinancing typically comprises 75% to 80% of mortgage origination division activity. HARP related refinancing have risen to as high as 30% of the total while refinancing activity for some weeks.
According to the FHFA, there were 1.1 million HARP loans refinanced in 2012, double the number in 2011. The agency also reported approximately two million loans have been refinanced under HARP inception in 2009.
With the expansion, some market participants expect there may be an additional 1.5 million to 2 million loans refinanced under HARP. The market has witnessed elevated prepayment fees in HARP eligible collateral and currently trade such securities to high prepayment assumptions.
The Mortgage Bankers Association refinancing index surged to near 5,900 in the week of September 28 after QE3 was announced on September 30, but then declined at year end bottoming at approximately 3,500 the week of December 28, typically one of the slowest weeks of the year. Refinancing index rebounded to approximately 4,900 on January, 18 but then declined steadily to under 4,200 by the end of March.
With the market reversing mid-March with index is scintillating to just over 4,800 for the week ended April 26. The Freddie Mac survey rate decreased steadily after QE3 announcement, falling from 3.75% the week prior to the announcement to 3.47% on December 7.
The survey rate ended 2012 at 3.52% and rose steadily into the first quarter peaking at 3.82% the week of March 15. With the market reversal, the survey rate ended the first of 3.76% and this since fallen to 3.60% for the week ended April 26.
Given the loss price is most agency MBS pretty straight up, today the market is exposed to an interest rate reversal. While market participants are concerned with their inability to actively hedge such a move, especially the effects of convexity on an MBS portfolio.
There has been clear evidence of this in the IO market since QE3 was announced as prices have been bid up to very high levels since IOs and natural hedges for pass-through securities advance the reason they would be in high demand given the current market environment. We also have the Federal Reserve and the government attempting this further refinancing activity by QE3 and HARP II this is elevated prepayments fees expectations, as a result in a historical context IOs have been trading at very low yield levels, especially sold during the fourth quarter of 2012 when many trades and negative yields.
Prices have moderated in Q1 and now most securities we look at offer yields in the mid-to-high single digits. Both this investment strategy was based on the allocation of capital into two sub-portfolios, the pass through MBS portfolio and the structured MBS portfolio.
Our structured MBS portfolio consists of interest only and inverse interest only securities. The pass through MBS portfolio was encumbered under repurchase agreement funding, while the structured MBS portfolio is not.
As a result of being encumbered, the past year MBS portfolio were request us to main adequate cash to meet price into our prepayment related margin cost from our lenders. We have deployed the capital from our IPO and so during moved the portfolio closer to a balanced mix of pass through and structured strategies in comparison to where we were at year end.
The allocation of capital into the pass-through portfolio was 60% at year end then was less than 20% or 52% at March 30, 2013. The mix of pass through securities results in a more skewed toward fixed rate bonds with 20 and 30 on maturity bonds approximately 40% of the portfolio 10 and 15 years bonds approximately 18% of the portfolio.
The added duration of the fixed rate bond is outlaid by the better net interest spread we have been able to generate versus high version shorter resetting arms. The combination of structured securities and hedges enables us to keep our overall model duration slightly negative despite of the heavy skew towards fixed rate MBS.
In order to achieve a slightly negative profile the company purchased structured securities and entered into derivative financial contract to hedge its future borrowing rates. As of March 31, 2013, the company has funding hedges in place for approximately 79% of its current rebuild out.
The aforementioned profile has been parallel shift in the interest rate curve and no well to change in the treasury mortgage basis. These curve and basis risk are hidden as the portion of the edge retail position increases as it did in the first quarter.
As I mentioned previously, our securities have become slightly more attractive versus where they were in the fourth quarter of 2012. As a result, we have increased the allocation structure securities from approximately 40% at year end to just over 48% at March 31, 2013.
The structured securities are now bias towards IOs versus inverse IOs at year end. The objective in the specific type of securities were sub-portfolio have not changed.
We are focused on avoiding prepayments and paying high premiums over TBA prices in order to do so. This is not easy, but so far we have been very successful in doing so.
With respect to the structured securities portfolio, the objective is nearly the opposite. In order to obtain the convexity we need from the IO and inverse IO securities to maintain the overall duration of the portfolios close to zero as we can specifically when rates move, we launched our own securities backed by collateral that is well on the money and paying fast.
These generate high yields as I discussed previously but if rates were to rise and mortgage cash flows extended as refinancing activity slowed, these securities should do quite well. Looking now to the portfolio for the quarter, speeds on passion portfolio securities were 9.2 CPR in Q1 versus 1.1 in Q4 of 2012 and 11.0 CPR in the first quarter of 2012.
The structured securities portfolio prepaid at 33.0 CPR for the first quarter of 2013, a decrease from 42.3 CPR in Q4 of 2012 and a slight increase from 31.2 CPR in the first quarter of 2012. Given the development surrounding HARP II and the continued effects of QE3, we expect these structured securities to remain elevated going forward.
The market developments during the quarter I have discussed result in a slightly negative mark-to-market adjustment on the pass-through portfolio of $0.4 million. We also realized a small gain of $0.1 million on the sales of $57.8 million of pass-through predominantly fixed-rate bonds.
We had $0.4 of mark-to-market gains on the structured securities almost all of which was on IOs. The invest IOs were down slightly in price.
Note that most of these mark-to-market gains and losses pertain to securities purchased after the IPO which closed February 20. We did not sell any structured securities during the quarter.
With respect to our interest-rate hedges, we generated mark-to-market losses of $0.05 million. We utilized A dollar features exclusively for our funding hedges.
We currently are short 250 contracts for each quarter through December of 2017. We anticipate we will use additional instruments to hedge going forward.
The weighted average funding rate on our repurchase agreement funding was 42 basis points for the quarter, we had approximately 316 million of repurchase agreement funding in place with nine counterparties at quarter end. Our funding arrangements are predominantly for 30 days.
Our leverage ratio at March 31, 2013 was 6.3 to one. Turning now to our results of operations for the quarter we reported GAAP net income of $0.04 million for the three month period ended March 31, 2013 compared with net income of $0.06 million for the three month period ended March 31, 2012.
Included in the results of the first quarter of 2013 are $0.04 million of net and realized and unrealized losses on the NBS portfolio and interest rate hedges. The company recorded $1.4 million of interest income of about portfolio with $237.8 million average market value balance for the quarter.
This resulted in an effective yield of 2.38%, down from 4.3% in the first quarter of 2012 and the portfolio had an average market value of $70.6 million. The realized yield on our pass-through portfolio which we define as interest income divided by average outstanding balance for the quarter decreased from 3.43% to 2.54%.
The realized yield on the structured securities portfolio income reported divided by the weighted average market value of securities held decreased from 10.56% to a negative 0.06%. As mentioned the type of securities we acquire IOs and inverse IOs collateralized by loans made to borrowers were generally refinanced in the current environment are now priced at higher prepayment rates.
Under GAAP accounting, we set our asset deals at the beginning of each quarter and therefore yields are a function of market conditions at the time. Accordingly, yields on our structured securities are flat to current market conditions.
Our book value per share at March 31, 2013 was $14.98. Book value per shares regularly uses a valuation metric by various equity analysts that follow us and may be deemed a non-GAAP financial measure pursuant to Regulation G.
We compute book value per share by dividing total stockholders' equity by the total volume of shares outstanding of our Class A common stock. Thank you to our shareholders who have supported us and I will now open the call up to questions.
Operator?
Operator
Thank you (Operator Instructions) We have a question from David Walrod of Ladenburg. Your line is open.
David Walrod – Ladenburg Thalmann
Hello.
Robert E. Cauley
Yes, you are on.
David Walrod – Ladenburg Thalmann
Perfect guys. I wanted to go through the $400,000 losses that you have on your income statement.
Can you break that out and you said it's broken out between mark-to-market losses, gains on securities and funding hedges. Can you break out each of those buckets for me please?
G. Hunter Haas, IV
Sure. Let me get in front of me.
I can talk about the top of about – the funding hedge was about $484,000 loss.
David Walrod – Ladenburg Thalmann
Okay.
G. Hunter Haas, IV
Then with respect to gain, we had a gain on the sale of low under $100,000.
David Walrod – Ladenburg Thalmann
Okay.
G. Hunter Haas, IV
And then we had on mark-to-market with respect to the IOs and inverse IOs, it was a positive $393,000. And then on the pass-throughs those two numbers that’s a pure mark-to-market number of $163,000.
And then there is about another $260,000 which is just premium loss. Since we don’t exclusively amortize premium, we capture that through pay down in the mark-to-market.
Okay so the $163,000 is just general mark-to-market.
David Walrod – Ladenburg Thalmann
Right.
G. Hunter Haas, IV
And then what was the second number?
David Walrod – Ladenburg Thalmann
$260,000 and that serves as premium amortization.
Robert E. Cauley
Yes, effectively.
David Walrod – Ladenburg Thalmann
Okay so there’s positive mark-to-market on the IOs and IIOs and then a negative mark-to-market on the pass-throughs and actually I have given you a breakdown of that with respect to the two structures, inverses were down and price slightly, was about $43,000 loss and the IOs were up about $436,000. Okay.
The other question I had was in regards to the expense line as far as the audit and professional fees as well as the G&A, I guess what was going on there, I was under the impression that those would not be allocated to work it until the company grew to a larger size.
G. Hunter Haas, IV
Overhead costs are not allocated, but direct company costs are audit. Most of that number that you are referring to is the professional fees is the audit [XPDO], the 10-K, most of that was actually three IPOs actually.
David Walrod – Ladenburg Thalmann
Okay.
G. Hunter Haas, IV
Because we had the way it was working Dave is that, we were having audits done, we work in a level even though it was not public and so as we approach year-end we weren’t sure when exactly we would get an IPO done. So we hadn’t accrued anything for the audit fee, then we did crude at the year end and it look like we're going to go ahead with the IPO, those costs were actually booked free IPO and that's about 120,000 of that.
Subsequent to that, once we became public on February 20, we put in place a new engagement letter with the auditors going forward and we’ll start accruing with that. That is a direct company cost that is not something that’s subject to the overhead sharing agreement which as you mentioned the $100 million cut off.
David Walrod – Ladenburg Thalmann
Okay. Thanks for clearing that up, and that's all from me.
Thanks a lot.
Robert E. Cauley
Hey David, if you have any more, please call we’ll be here all day.
David Walrod – Ladenburg Thalmann
Okay, thanks.
Operator
Thank you (Operator Instructions) Our next question is from Terry Mcevoy of Oppenheimer. Your line is open.
Terry Mcevoy – Oppenheimer & Co.
Hi, good morning.
Robert E. Cauley
Good morning.
Terry Mcevoy – Oppenheimer & Co.
About 52% of your capital allocated towards the pass-through portfolio. I’m just wondering if you give us a better understanding of what you need to see or what you are looking at from a macro perspective before you bring that down and increased the structure to MBS portfolio and any sort of timing of that shift?
Robert E. Cauley
I’ll give you my comments and I’ll turn that over to Hunter. It’s a bigger – as you alluded to, it’s a big picture decision.
We are looking at the end of the day, the profile of the portfolio, the sensitivity of the entire portfolio to rise. And we try to get as close to zero as we can and the way we do that is a combination of basically three tools.
Pass-through is what you got the most, pass-through portfolio which is generally income generating vehicle only. Then you have funding hedges which can play a role of a asset hedge and in the structured securities.
And so depending on market conditions, what’s available in the market, the types of assets on the structured that are available to us at any given time, we will be able to derive from that information just how much protection we can get and at what cost. So for instance, if you were going back into late fourth quarter of 2012, IO pass-through are really (inaudible).
So if you are looking at a lot of upgrade protection from IOs, you are accepting negative yields in many cases of very, very low single digit yields. And so you might decide that time to use your funding hedge a little more than you would otherwise.
Since that time, prices on IOs have softened up a little bit, now you can get more attractive yields and we could still get that upright protection. So the big picture item before I turn – on characterization before I turn over to Hunter is just that, we are looking at the end of the day to try to create a flat profile using these three tools and we basically look at what the market offers us in any time and that pretty much determine how we use those tools in what relative proportion.
G. Hunter Haas, IV
I would just add, I agree with all Bob said and I would just add that, as rates become lower and lower as we’ve seen since the fall of last year. We’ll tend to allocate more towards the pass-through book.
The funding hedges we use have a little more convexity when they are found by zero so to speak. So in other words we have very limited downside using those traditional hedges, swaps and your balance sheet just only go down to a zero rate and the upside looks a lot better.
So we can hedge a little bit more than mortgage convexity how using those types of estimates. We think we’ve seen peak speeds and to the extent that the IO market has adjusted in price and isn’t quite as tight it was, which is something that we’ve actually sort of witnessed in the month of April, and I guess coming in at early May, we’ve seen a little bit of distraction in the structured products market, especially (inaudible).
We will opportunistically shift back a little bit of that allocation more destruction products to the extent that we can continue to meet our earnings and risk management objectives.
Terry Mcevoy – Oppenheimer & Co.
Thanks. And just a follow-up, I understand the strategy of protecting book value rising rate leverage.
Could you just maybe quantify what you sacrifice from an ROE perspective from having that strategy just so we can compare it to some other companies out there to get more of a balanced view of those strategies and maybe some of the short-term sacrifices to have the protection and the balanced strategy that you guys has talked about?
Robert E. Cauley
Sure. The environment for the last six months have caused us fairly high.
The structured securities portfolio, under what I won’t call normal market conditions, that is pretty allusive term to define at the moment. The free crisis that's going back away, but those securities would typically generate yields in this mid-teens on average and sometimes you can buy a structure at IO would have a yield in the 20’s and the trust IOs which are the most liquid and safest market or may be high single digits.
So on average, you could certainly get mid-teens. In this environment, those numbers are not available and so the trade off is much higher.
As I said today, you can probably get mid-to-high single digits on average and in the past two portfolio getting mid-teens is very obtainable. So you’re looking at five plus points minimum sacrifice to get that kind of protection and it was higher late 2012.
Terry Mcevoy – Oppenheimer & Co.
Right, very helpful. Thanks guys.
Operator
Thank you. There are no further questions at this time.
I like to turn the call over to Mr. Cauley for any closing remarks.
Robert E. Cauley
Thanks. Everybody I appreciate your time taken to listen.
To the extent anybody has any additional questions or if they happen to listen to the replay, something was unclear, you want to ask additional question that was not asked today, please be sure we will be available all day and into next week. So I thank you for your time and again anybody has any additional questions, please feel free to call the office, we are glad to go over pretty much anything you can ask.
Thank you, operator.
Operator
Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program.
You may now disconnect. Have a wonderful day.