Earnings Transcript for AAIC-PB - Q3 Fiscal Year 2021

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Operator: Good morning. I'd like to welcome everyone to the Arlington Asset Third Quarter 2021 Earnings Call. Please be aware that each of your lines is in a listen-only mode. After the company's remarks, we will open the floor for questions. I would now like to turn the conference over to Ben Strickler. Mr. Strickler, you may begin.

Ben Strickler: Thank you very much. And good morning. This is Ben Strickler, Chief Accounting Officer at 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 president 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 SCC from time-to-time, which are available from the company and from the SCC 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: Thank you Ben. Good morning and welcome to the Third Quarter 2021 Earnings Call for Arlington Asset. Also joining us on the call today is John Murray, our portfolio manager. Beginning last year, the company initiated a process of identifying and evaluating various investment strategies that complement its historical focus over levered agency mortgage investing and leverage the company's historic expertise in the mortgage, housing, and structure products sectors. The company's primary objective was to establish platforms where partnerships could provide the pathway to deploy capital into less commoditized investments with high barriers of entry that offer attractive, unlevered returns and also provide the opportunity to use term financing structures where available. We are pleased to announce that we have made substantial progress towards the execution of this strategy, having constructed a unique portfolio of differentiated, high return asset classes with compelling growth opportunities in large scale markets, which combined favorable risk return profiles and low leverage. We have successfully established new investment channels over the past year that allow the company to allocate capital in the Mortgage Servicing Rights, single-family residential rental properties, and selective mortgage credit opportunities. These new investment channels should complement the company's existing agency mortgage strategy, diversify risk, and improve the level and reliability of returns over time. We believe the formation of our differentiated investment strategy creates strong building blocks for the company's future growth, profitability, and value creation for shareholders. To be able to invest in Mortgage Servicing Rights, the company established a strategic relationship with a licensed GSE -approved servicer that enabled the company to garner the economic return of investment in Mortgage Servicing Rights without holding the requisite license directly. Under the terms of our partnership that 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. At our option and direction, our partner has the capacity to add leverage to increase potential returns to us. We believe this efficient, cost effective, and lower risk channel for investing in the economics of Mortgage Servicing Rights differentiates Arlington. The company has grown it's MSR portfolio at attractive entry points over the course of the year to 36% of its Capital as of September 30th. The on the company's MSR portfolio is currently under 3%, which is unique in the marketplace, given the portfolio almost has no production before pre -second half 2000. Year-to-date, the company's MSR portfolio has produced high single-digit current cash returns along with asset appreciation through multiple expansion that has resulted in very attractive year-to-date annualized total returns, while employing very modest leverage of 0.1 as of quarter-end. Newly created mortgage servicing rights of Fannie Mae and Freddie Mac loans continue to offer attractive return opportunities while providing a strong complement agency MBS investment characteristics. At current purchase price, multiples of approximately four times for current coupon MSRs, unlevered MSR investments offer base returns in the high single-digits. Turning to leverage agency MBS, we're currently seeing available returns in the high single-digits with an appropriate hedge position aided by ongoing low repo costs. However, with the Federal Reserve recent announcement to begin tapering this month, an increased market expectations that the Federal Reserve will begin to raise short-term interest rates next year, the volatility around agency mortgage investing could increase. Against this backdrop, and the still historically rich valuations, the company continues to remain cautious about significantly increasing leverage and capital allocation to it's levered agency mortgage strategy. With their complementary characteristics, combining investments in levered agency, MBS and MSRs should decrease overall risk while increasing ROE. Mortgage Servicing Rights 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, MSR is offering attractive standalone return in the high single-digits and by reducing the need for interest rate swaps as a hedge for agency MBS and their associated costs. MSRs provide a positive carry hedge for leverage Agency Securities. Replacing negative carry swaps with positive carry MSRs turns the largest drag on levered agency MBS returns in the current environment into a carry positive. And during the third quarter, the company reduced its negative carry interest rates swap hedge position on its agency MBS investment portfolio, as the company increased its positive carry MSR investments. Which should improve combined returns going forward without meaningfully changing the company's interest rate risk posture. As of September 30th, the company's duration gap of it's hedged agency MSR and MBS portfolios was relatively neutral at positive 0.1 years. After a comprehensive evaluation period, the company is also pleased to announce that during the third quarter it launched the new investment strategy of acquiring, operating, and leasing single-family residential homes. The company believes the investment opportunity in single-family residential rentals offers attractive long-term potential returns supported by favorable supply demand dynamics, a healthy U.S. home financing market, and flexible financing structures with attractive returns for institutional investors. We expect the favorable dynamic in U.S. single-family residential homes to continue for some time, as we believe the limited supply of new homes will likely not meet the growing demand of housing based on expected demographic and home formation trends. The company's partnered with a leading global asset manager that is approximately $140 billion of assets under management, including approximately $1.1 billion invested in more than 4200 single-family residential properties. This relationship will enable us to leverage our partner scale, intellectual capital on access to compelling investment in growth opportunities in the vast single-family residential space. The Company has committed to initially invest at least $50 million of capital to acquire approximately $200 million of properties that we expect to lever approximately 3

Operator: Thank you. At this time, we will open the floor for questions. Questions will be taken in the order in which they are received. Our first question comes from Doug Harter with Credit Suisse. Please go ahead.

Doug Harter: Thanks. Rocky, you briefly mentioned this, but can you just talk about your -- the partnership for single-family rental on the operating side, how you plan to operate that and then if you could just also remind us of the partnership you have with the sub-servicing on the MSR side.

Rock Tonkel: Sure. Just starting with the servicing side. We've got a national servicer that we are partnered with, with a long experience in this -- in that arena. And I think, the capability of that partnership is borne out, to be honest, by the nature of the assets that we've been able to put in place and the performance. We've had a very disciplined process with our partner, works very fluidly. We've had on those loan pools for which we capture as relevant and our earlier ones it's not really relevant yet because we haven't hit the point yet where recaptures are really necessary, but we've had a good recapture experience, and we're optimistic about how that will move forward. And obviously our returns have been very handsome there and we don't have to absorb either the expense or the -- or more importantly, the regulatory burden of actually operating the servicer. So to us that's been a very favorable outcome to date. We're very enthusiastic about our partnership in the single-family rental business. This is a global financial institution on both the acquisition, refurbishment, and leasing side, as well as on the -- our financial partner on the financing facility, which we think is about as robust as one could find for a non-investment grade company in the space. And our partner is extremely capable and experienced. They've been in the business for at least, if not, more than a decade. And as I said in my comments, they own currently, and have owned over time, I suspect many more thousands of homes. But today, they own about 4,000 homes. They -- we and they work together through third-party property managers and refurbishment entities. And that is thus far it's early days, but the early results there are -- appear to be promising with the yields thus far at or above our expectations And the pace of our activity on track with our expectations, we wanted to take a bit of a patient approach to acquiring assets so that if there is a little bit of a pullback on the back of the appreciation we've seen over there in recent periods that we'll get the benefit of that with our new capital and going into the space. We feel like there is really exciting and explosive growth opportunity in that space for us. Honestly in both of these MSR and the SFR space, we think there are growth extensions off of the partnerships that we have created here that are quite innovative, we believe. And these growth extensions can be very powerful over time. We're already in conversation with different parties about potential growth pathways for us to capture the benefit of more scale and each of these two businesses. So we're very enthusiastic about both our return profiles and

Rock Tonkel: MSRs have been in excess of our expectations and our portfolio is at least as attractive as we expect it to be. We're very pleased with that partnership. And it's early days on the SFR side, but the same principles apply. Very pleased with the partnership, very accomplished, experienced, responsible, stable, sturdy party in our partner, and as good a financing partner in facility as one could ask for. So we're very pleased on both counts and excited about trying to capture what we think are potentially explosive growth opportunities going forward.

Doug Harter: Appreciate it. Thank you.

Operator: Thank you. Once again, . Our next question comes from Eric Hagen with BTIG. Please go ahead.

Eric Hagen: Okay. Thanks. Good morning. Maybe just 1 from me. What do you guys think is the right amount of liquidity in the sources of that liquidity to carriers? You guys move into these new strategies and you're also focused on buying back stock at the same time.

Rock Tonkel: Thanks, Eric. So as you may know, we've historically carried a very liquid Balance Sheet. We continue to seek to keep our overall liquidity very high. To-date, that's been accomplished through maintaining low leverage as well as a cross-section of assets that are highly liquid, including of course, the agency side. We do expect to continue to have a substantial participation in the agency side. It's the natural pair for the MSRs. And so obviously, that will be -- continue to be a source of capital for us. If you think about the MSR side and I think today, we're just a little above $100 million or so in capital, we've applied very little leverage there and we do have the flexibility to apply more over time, but we're cautious about that on the MSR side, as we have said in the past. In any event, if we've got, call it, a $100 million ish or a little more over. I'm just using a $100 million around numbers. That would apply that we'd want to have at least I think generally, as a general marker, $50 million or so, about half the amount of the MSR Capital in an agency long book. And so that together that's about half the capital between those two. Obviously the $50 million or so in agency side is liquid. We maintained a mortgage credit portfolio that has Cusip securities in it. And those generally tend to be liquid. As we sit here today with the expectation that, will grow our capital investment in the SFR to something like $50 million, well then that's going to leave us with solidly in excess of the, call it 150, in the agency MSR side and another 50 in the SFR side. That's going to leave us with somewhere between 1/3 and 1/2 of our capital that's pretty liquid. To the extent that we grow that MSR book or that SFR book a little bit over time, which is possible, I'm not telegraphing that that will happen, but it is certainly possible given the return characteristics in those and the strength of those, the robust partnerships that we've built there, that could extend somewhat. But as we sit here today, somewhere between 1/3 and 1/2 of the Balance Sheet of our capital is highly liquid. And that probably comes down a little bit over time. But I would think that we'd probably be trying to keep, give or take, 1/3 of our capital over time to be in a highly liquid form. So we'd have complete flexibility to adapt to new opportunities, to buy the stock, to assess what the best risk return was at any given day in time, between an incremental investment in our key strategies and buying the stock. And to be prepared with a low leverage approach for rainy days and buy little time so when they come into market, try to take advantage of them.

Eric Hagen: Thanks a lot. That's helpful detail. Appreciate it.

Operator: Thank you. Mr. Tonkel and team, there are no further questions in queue at this time.

Rock Tonkel: Okay. Well, thank you very much. We appreciate your time and your thoughts and if you have follow-up, please, feel free to give us a ring. Thank you very much.

Operator: Thank you all for your attention. This concludes today's teleconference. You may now disconnect.