Arlington Asset Investment Corp.

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. If you would like to ask a question, please press the star key followed by the one key on your telephone keypad. If you would like to remove yourself from the questioning queue, press star two. I would now like to turn the conference over to Ben Strickler. Mr. Strickler, you may begin.

Thank you very much and good morning. This is Ben Strickler, Chief Accounting Officer at 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 Tonkle for his remarks.

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 of levered agency mortgage investing and and leverage the company's historic expertise in the mortgage, housing, and structured product sectors. The company's primary objective was to establish platforms or partnerships that 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 combine 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 into 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 enables 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, 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. 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 its MSR portfolio at attractive entry points over the course of the year to 36% of its capital as of September 30th. The WAC 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 to 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 levered agency MBS, we are 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's recent announcement to begin tapering this month and 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 its levered agency mortgage strategy. With their complementary characteristics, combining investments in levered agency MBS and MSRs should decrease overall risk while increasing ROEs. 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, MSRs offer an 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 cost, MSRs provide 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. And during the third quarter, the company reduced its negative carry interest rate 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 its 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 a 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 has partnered with a leading global asset manager that has approximately $140 billion of assets under management, including approximately $1.1 billion invested in more than 4,200 single-family residential properties. This relationship will enable us to leverage our partner's scale intellectual capital, and access to compelling investment and 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 three to one. To finance the purchase of the properties, the company entered into a $150 million five-year secured term debt facility at attractive terms with a large and highly reputable financial institution. The debt facility has an 18-month draw period of fixed cost of funds of 2.76%, with very limited recourse to Arlington. Based on current conditions, the company expects its investments in single-family residential properties to generate current unlevered net yields of 4.5% to 5%. and levered yields of 8% to 12% plus the opportunity to realize home price appreciation on top of that current carry that could push total net returns toward the mid to high teens. The company is focusing on high quality newer homes and is currently active in seven growth markets in the Southeast and the Southwest. As of September 30th, the company had acquired 33 homes for an additional for an aggregate purchase price of $9.4 million and had commitments to purchase an additional 75 homes for a total purchase price of $19.9 million. As of November 2nd, we have acquired or have commitments to acquire a total of 178 homes for an aggregate purchase price of $52.4 million. The timing of the earnings benefit to the company from investing in SFR rental properties will be dictated by the pace of home purchases, the level of any property-level refurbishments necessary, and the length of the lease marketing period. We expect the time period between the date of settlement of the home purchase to the date the house is occupied by the tenant to average between 30 to 60 days. The evolution of the single-family rental market over time has increased liquidity to the asset class through potential bulk sales, as well as potential enhancements to profitability over time by accessing favorable funding characteristics using structural debt. Bulk sales can result in lower cap rates than individual home purchases, while securitized debt solutions for single-family rental offer reduced cost of funds and increased leverage based on recent market conditions, driving potential increases over time of 300 to 500 basis points in overall expected ROEs from single family rental investments going forward. The company also continues to identify and evaluate opportunities in mortgage credit investments that offer high risk adjusted returns, including residential business purpose loans, commercial mortgages, and non-agency MBS. The underlying credit performance of the company's mortgage credit investments produced solid results during the third quarter, supported by a strong economic environment. Turning to the actual results for the quarter, the company reported book value of $5.97 per share as of September 30th, a slight increase from the prior quarter end. The company continued to operate with overall low leverage and significant financial flexibility with its overall at-risk leverage ratio standing at 1.8 to 1 as of September 30th. For the third quarter, the company reported a gap net loss of $0.03 per share and core net operating income of $0.06 per share. During the third quarter, the company continued to return capital to shareholders through accretive stock repurchases by repurchasing 3.3% of its outstanding common stock that accreted $0.07 per share to book value. The company has repurchased approximately 16% of total shares outstanding to date, and has a large remaining authorization from its board. The company will look to continue to return capital to shareholders by opportunistically repurchasing shares of common stock at highly accretive prices. This is an exciting time of positive and dynamic growth at Arlington. The company is very encouraged by the progress it has made in the transition to its objective of complementing its core agency MBS portfolio with high-return non-commodity investment channels in mortgage servicing rights, single-family rentals, and mortgage credit. We have created innovative partnerships in non-commoditized businesses, which provide access to scaled high-return opportunities. We are active and growing in the MSR and SFR businesses, making Arlington a unique and differentiated platform in the small-cap arena. Our new businesses offer attractive double-digit return profiles, well-structured, which currently trade at valuations in the market above book value. We are optimistic about completing our goal of building a differentiated investment platform that should generate higher returns, reduce overall risk, and increase earnings power over time that can form the pathway for returning more capital to shareholders in the future. Operator, I would like to now open the call for questions.

Thank you. At this time, we will open the floor for questions. If you would like to ask a question, please press the star key followed by the 1 key on your telephone keypad now. Questions will be taken in the order in which they are received. If at any time you would like to remove yourself from the questioning queue, press star 2. Our first question comes from Doug Harder with Credit Suisse. Please go ahead.

Thanks, Rocky. You briefly mentioned this, but can you just talk about the partnership for single-family rental on the operating side, kind of how you plan to kind of operate that, and then if you could just also remind us of kind of the partnership you have with the subservicing on the MSR side?

Sure. Just starting with the servicing side, So we've got a national servicer that we are partnered with, with a long experience 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 recapture is 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, 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 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. We and they work together through third-party property managers and refurbishment entities, and that is thus far its early days, but the early results there appear to be promising with 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 in recent periods, that we'll get the benefit of that with our new capital and going into the space. We feel like there's 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 in each of these two businesses. So we're very enthusiastic about both. Our return profiles and 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 and 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.

I appreciate that. Thank you.

Thank you. Once again, to ask a question, press star 1. Our next question comes from Eric Hagan with BTIG. Please go ahead.

Hey, thanks. Good morning. Maybe just one from me. What do you guys think is the right amount of liquidity and the sources of that liquidity to carry as you guys move into these new strategies and you also focus on buying back stock at the same time?

Thanks, Eric. 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 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 100 million-ish or a little more over time, I'm just using 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, you know, together that's about half the capital. Between those two, obviously the $50 million or so in the agency side is liquid. We maintain a mortgage credit portfolio that has QSIP securities in it, and those generally tend to be liquid. As we sit here today with the expectation that we'll 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, you know, call it 150 in the agency MSR side and another 50 in the SFR side. You know, that's going to leave us with somewhere between a third and a half 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, you know, the robust partnerships that we've built there. That could extend somewhat. But as we see there today, you know, somewhere between a third and a half of the balance sheet of our capital is highly liquid. And that probably comes down a little bit over time, but, you know, I would think that we'd probably be trying to keep give or take a third 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 and 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 volatile times when they come in the market, try to take advantage of them.

Thanks a lot. That's helpful detail. Appreciate it.

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

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.

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