Arlington Asset Investment Corp.

Good morning. I'd like to welcome everyone to the Arlington Asset first 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. If you would like to ask a question, please press the star key, followed by the one key on your touch tone phone now. If you'd like to remove yourself from the question queue, press star two. I would now like to turn the conference over to Rich Consman. Mr. Consman, you may begin.

Thank you very much and good morning. This is Rich Consman, Chief Financial Officer of Arlington Assets. 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 statement. I would now like to turn the call over to Rock Tonkel for his remarks.

Thank you, Rich. Good afternoon and welcome to the first quarter of 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 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 31st, 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 the sufficient 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 fourth 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 31st, 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 multi-year tights, 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 on levered 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 31st, the MSR portfolio we now hold with unpaid principal balance of $6.4 billion $67 million of capital invested, and a WAC 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, 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 meet the company's objectives for low leverage, strong returns, diversification of risk, and term or non-marginal 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 in 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 31st, a decline of 3% from the prior quarter end. As of April 30th, the company's book value per share increased approximately 1% since quarter end. The company continued to operate with low leverage and significant financial flexibility, with its overall at-risk leverage ratio standing at 1.4 to 1 as of March 31st, a decline of one turn from year end. For the first quarter, the company reported a gap 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 pay down 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 continued 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 carry-forwards 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 the transition towards 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'd now like to open the call for questions.