Arlington Asset Investment Corp.

Good morning. I'd like to welcome everyone to the Arlington Asset fourth quarter and full year 2021 earnings call. Please be aware that each of your line 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 touchtone phone. If you'd like to remove yourself from the questioning queue, please press star two. I would now like to turn the conference over to Richard Konsman. Mr. Konsman, you may begin.

Thank you very much. Good morning. This is Rich Konsman, 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 the 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 morning, and welcome to the fourth quarter 2021 earnings call for Arlington Asset. Also joining us on the call today is John Murray, our portfolio manager. The company is pleased with the progress it has made towards its goal of establishing multiple high-return, non-commodity investment channels, that should both diversify investment risk and improve reliability of returns over time. Having established new investment silos over the past year in mortgage servicing rights, single-family residential rental properties, and selective credit opportunities, the company has successfully allocated capital into new investments that complement its historical agency mortgage strategy and position the company for strong growth in shareholder value over the long term. Going into the fourth quarter, our primary goal was and continues to be to protect shareholder capital from the impact of inflation, rising rates, and Federal Reserve monetary tightening policies while maintaining low leverage and plentiful liquidity. During the fourth quarter, we traded the potential for short-term incremental core operating income from levered agency MBS in exchange for capital preservation and potential long-term capital growth by lowering the company's investment allocation to agency MBS and accompanying mortgage basis risk. At the same time, the company continued to expand its investment allocation towards MSRs, single-family rentals, and opportunistic credit investments that collectively should perform well in a rising rate and inflationary environment while being defensive versus an expected Federal Reserve tightening. The company has grown its MSR portfolio at attractive entry points over the course of the year to 43% of its capital as of December 31st. That portfolio has produced year-to-date high single-digit current cash yields along with asset appreciation through multiple expansion that has resulted in a year-to-date total return of 34% all while employing very modest leverage. As of year end, the company's MSR investments had $158 million of underlying mortgage servicing rights, valued at a multiple of 4.38 with leverage of just 0.3 times. Newly created mortgage servicing rights of Fannie Mae and Freddie Mac loans currently offer unlevered yield opportunities in the high single digits with the potential for further multiple expansion if rates continue to rise. The company continued to make significant progress in its recently announced strategy of acquiring, operating, and leasing single-family residential homes. The company believes the investment opportunity in single-family residential offers potential attractive long-term returns supported by favorable supply-demand dynamics, a healthy U.S. home financing market, and flexible financing structures with attractive terms 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 trends. And in a high inflationary environment, investments in single-family residential rental properties should benefit from home price appreciation and rental income growth. As of December 31st, the company has acquired or committed to acquire 283 homes for $83 million. As of today, we have either acquired or committed to acquire a total of 412 homes for $125 million. Overall, the company has committed to invest at least $50 million of capital to acquire approximately $200 million of properties. To finance our SFR properties, the company has a $150 million five-year secured term debt facility with an 18-month draw period at an attractive fixed cost of funds of 2.76% with limited recourse to Arlington. The company expects its investments in SFR properties to generate average current unlevered net yields of 4.5% to 5%. and levered net yields of 8% to 11.5%, plus the opportunity to realize any home price appreciation. To date, we are pleased with the progress we have made in building our SFR portfolio and its expected average unlevered net yield of 4.9%. 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 we make, and the length of the lease marketing period. We expect that time period between the date of settlement of a home purchase to the date the house is occupied by a tenant to average between 30 and 60 days. Accordingly, during its initial ramp period, our SFR portfolio has not yet contributed to current earnings. We believe that is an opportunity for us going forward. Once the company's $50 million of committed capital in SFR is fully scaled, the company expects to generate double-digit returns on the capital that is not currently reflected in the company's earnings. The company is also encouraged by the potential appreciation value the company may realize in its SFR portfolio over time, none of which is reflected in its book value today, as these assets are carried at the historical depreciated cost basis of the property. The company also continues to identify and evaluate opportunities in credit investments that offer high risk-adjusted returns, including securitizations of residential solar panel loans and non-agency residential MBS. Turning to the actual results for the quarter, the company reported book value of $6.16 per share as of December 31st, a 3.2% increase from the prior quarter end. Furthermore, the company's book value per share grew an additional 2.5% in January, and we believe has remained relatively unchanged from there during the month of February. The company continued to operate with overall low leverage and significant financial flexibility, with its overall at-risk leverage ratio standing at 1.5 to 1 as of December 31st. And for the fourth quarter, the company reported gap net income of $0.10 per share and core operating net income of $0.02 per share. With the company's stock trading at a significant discount to its book value, the company continues to aggressively repurchase shares of its common stock. During the fourth quarter, the company repurchased nearly 4% of its outstanding shares of common stock and accreted $0.09 per share to book value. Subsequent to year-end, the company has already purchased 2.5% of its common stock outstanding, and it created an additional $0.07 per share to book value. Since reinstituting its current common stock repurchase program in 2020, the company has repurchased 7.7 million shares of its common stock, or nearly 21% of outstanding shares. The company has a substantial remaining authorization of over 12 million shares from its board, to repurchase shares of its common stock, and the Board is prepared to increase that authorization if necessary. At current stock price levels, the company intends to return capital to shareholders through aggressive stock repurchases. Overall, we are very encouraged by the progress the company has made to date in its transition toward its long-term goals and is optimistic about its prospects going forward. The company has taken positive steps toward its objective of complementing its core agency MBS portfolio with high-return, non-commodity investment channels in mortgage servicing rights, single-family rentals, and opportunistic credit investments while operating with balance sheet flexibility through low leverage and high liquidity. As I indicated, we believe there is untapped earnings power yet to be generated from the existing portfolio. We continue to evaluate attractive opportunities for investments that fit our criteria for programmatic platforms with non-commodity return characteristics, which can further add to shareholder value. And we believe that over time there are potential additional growth paths for our existing asset silos beyond the scope of our current capital base. As always, we will evaluate those opportunities and the use of capital to support their long-term value creation compared to the benefits of repurchasing the company stock or other potential distributions to shareholders. We are optimistic that the company's current diversified investment strategy can deliver attractive long-term returns to shareholders while the company maintains the financial flexibility to return capital to shareholders through accretive stock repurchases at today's current stock prices. Operator, I'd like to now open the call for questions.

Thank you, sir. 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. That is star 1 on your touchtone phone now. If at any time you would like to remove yourself from the questioning queue, please press star 2. Thank you. Our first question will come from Doug Harder with Credit Suisse.

Thanks, Rock. Just wanted to follow up on one of the last comments you made as you kind of weigh new investments versus buybacks. Obviously, you've been, as you mentioned, aggressive in buying back the stock. But I guess given the discount, how do you weigh the potential to continue to do that, be more aggressive in versus the returns you see? Just a little bit more thought on how you and the board are thinking about that.

Well, I think, Doug, we think about that naturally every day and observe the stock price closely. And as you noted, we've been aggressive buyers, and we continue to be aggressive buyers. We've been buyers corporately. We've been buyers personally. And I would expect that those both would continue. at these levels. So obviously there's a calculation there that's ongoing that relates to the level of the capital and the scale of the organization versus a few things. It's G&A and liquidity to stock and those sorts of things. I think we've been fortunate that we've been able to bring expenses down pretty significantly over the last couple of years and And that gives us even more flexibility in that equation. I'm not sure there's an enormous amount left against this pretty massive inflationary tide, but that's been a bit of a boost and a wind in our back and giving us flexibility to be buyers of the stock without really changing the G&A burden on the company. And so we feel like at this level of capital with a level of appreciation that's occurred in our assets, and that we would be hopeful would continue to occur, that we would have the opportunity from both current earnings, potentially appreciated capital, and potentially the use of existing capital to buy the stock at these levels, and find a balance between that and the high returns that we can generate from non-commodity silos like MSRs, SFRs, and others like that that we are constantly evaluating. I think we all feel as a team that we need to be able to do both in pursuit of the shareholders' best long-term interests, and we're adjudicating that every day. Clearly, at these prices, a substantial amount of capital is going into the buyback, and we would expect that we would continue to be aggressive there. but that does leave us still with flexibility in the capital structure to invest additionally in the silos that we have or potentially add to them. Remember, we keep very low leverage in the overall portfolio, one and a half times, and we think that we can add earnings power, not only extract the earnings power that is yet to be extracted from the existing portfolio over coming months, But we can potentially add to that with additional return opportunities that can generate more capital to be utilized for distribution or repurchases of stock. Got it.

And just to follow up on the cost and the stock liquidity, is there a minimum size of equity or market cap that you feel would be necessary to maintain the efficiency of the business and just how are you thinking about how much of the company you could continue to buy back if the valuation didn't change?

We're looking at that in the context of assessing the long-term value that can be created from the pursuit of these existing silos to their full scale on the one hand versus the current one-time but very significant benefit of buying the stock. And we're looking at it from the standpoint of what is the franchise value that may be attached to those two silos and others we may add above book value and present value that against what the current returns on the equity are. Where that has led us so far is that with the kinds of returns that you see in these assets, we continue to believe that reinvesting part of the capital into those asset silos and to the extent we identify others that can generate returns, pretty extraordinary returns of the nature you just heard about, well, then we will continue to do that as well as buy the stock.

I appreciate the answer, Brock.

Thank you. And we look at that, the pursuit of that value, as more of a priority than focusing on exactly where the final market cap of the stock lands.

Understood. Thank you. From a scale perspective, I mean.

Thank you. Our next question comes from Jason Stewart with Jones Trading.

Hey, good morning. Thanks for taking the question. Rock, maybe you could talk a little bit about what your expectation is for volatility around the MSR. I mean, given how low the underlying mortgage rates are struck there, I'd be curious to hear your thoughts on the current rate move and where you think sort of a top-end valuation is given, at least in my view, that it's still relatively low in terms of a valuation.

Well, it's a great question, Jason. I think it's actually quite interesting that even as the MSR market pricing context for our coupon type MSRs has evolved, you know, from threes to fours to now evolving toward five multiples. I actually am encouraged and we are encouraged by the resilience that they show on a modeled basis. relative to rates moving in both directions, but particularly from a down rate perspective. One might have thought that as the valuations had improved pretty meaningfully, that therefore the volatility of return in a down rate scenario might have escalated. And in fact, we find today that that does not appear to be true, that even as these assets have appreciated toward five times multiple, that they continue to be quite resilient from an interest rate move perspective. I think we feel like we've got 25 to 50 basis points of down rate move before we see meaningful downside price volatility. That isn't to say that there wouldn't be any, but... But in terms of seeing some price movement that's other than marginal, I think we feel like 25 to 50 bps down is the point at which you start to see some of that. And we view that as a positive risk-reward dynamic. As to the upside... You know, I think our modeling would say that there's potential upside toward six on a multiple basis. Might not get to six. Might be somewhere, you know, sort of shy of that. But that would imply, you know, something like at least a multiple, an additional multiple of turn from here. I think our latest valuation was around 4.7 or 4.8. And so that would imply, you know, a point or so of additional multiple addition. And obviously that's pretty meaningful, right? That's, you know, a point on 4.7 or 4.8 is pretty meaningful additional appreciation. So we're not predicting that that will happen. We just sort of feel like, you know, that seems like an upward boundary. And on the other hand, the down rate sensitivity we feel is quite resilient.

Great. That's helpful. And if you don't mind, do you have an estimate of what your view on natural turnover is for the MSR portfolio? Just sort of get like as a floor.

I'd say it's in the neighborhood of, you know, high single digits.

Got it. Okay. That's helpful. Thank you for that.

And then switching to, you know, eight, eight, you know, high single digits. Maybe it gets to 10, but it feels like it's below that feels like, Seven to nine, something like that feels like a good level.

Got it. All right. That's helpful. Thank you. And then on SFR, in terms of the way you're thinking about growing that business, are there geographies that you're focused on? Maybe a sense of where you're thinking the best opportunity for capital deployment is?

That's an interesting question. Our portfolio is sort of strung from the southeast along the south to the south. sort of the near southwest. I think our farthest western market is sort of Texas. Our portfolio works from Charlotte down around the south over to Dallas. That's our concentration. In the overall scope of SFR, our portfolio is relatively small, so we've got sort of boundless room. for opportunity there. We've been very encouraged, very encouraged by the quality of the homes that we've been able to put in portfolio, the quality and level of rent collections and yields. And so we're so far very pleased with that. You know, there's diversity in the types of markets, right? Those that are viewed as the most core markets are a little more expensive. You're going to pay a little more. You're going to get a little bit less yield. Those yields are going to be closer to, you know, low fours. you know, maybe mid-fours, whereas some of the other markets that aren't quite as core, you get more yield out of. And those are going to run $4.75, $5, $5.25. But there are substantial population and income growth occurring in those markets that is driving higher yields and very encouraging rent growth now and we would expect going forward. So, you know, there's a complementary nature of our markets. The houses are pretty common across those markets. They're inside 10, 12 years old, so they're relatively new. They don't require a lot of refurbishment. They are truly in a sort of core-type properties. in the SFR market, and yet our yields are very healthy. 4.9 is a pretty healthy, pretty, I'd say very healthy yield in that market. And of course, we benefit from having the ability to finance that against the 275, 276 five-year fixed rate structure, which generates, you know, the kinds of, you know, double-digit, you know, very, very meaningful double-digit returns, you know, we would expect in that asset class going forward. Maybe, maybe over time, depending on appreciation, in the 20s. That would completely depend on the level of appreciation. But even with modest appreciation, given the character of this portfolio, the unlevered yields, the quality of the underlying homes, we feel like we can generate double-digit returns of value. of one level or another, and maybe exceptional ones.

Great. Thank you. That's helpful.

Thank you. Our next question comes from Christopher Noland with Ladenburg Bauman.

Hi, Chris. Hey, guys. What's the return on the SFR portfolio in the quarter, please?

For Chris, it was not very meaningful for the quarter. Cause as you remember, or think about it, we have to ramp up these portfolios. And from the time we settled the house to the time that there's a tenant paying rent in the house is usually an average around 30 to 60 days. Uh, because of any kind of refurbishments, we need to do the property, any lease marketing period. Um, so for the quarter, I think it was a small loss of a few hundred thousand dollars. So, you know, pretty, pretty negligible for the quarter. And as we continue to ramp up the portfolio, you know, until it's fully ramped, meaning that people fully invest that $50 million of committed capital to buy about $200 million of homes, you know, there's going to be a lag period as we ramp up that portfolio.

Great. And then for these properties, are you guys the owner of record or does your partner own it? We own it. Yeah, the title of the homes are in our name. So in the case that you have a renter who decides not to pay rent and sort of take you through the landlord-tenant courts, that would show up as a non-accrual loan?

Well, it's not a loan. It's a rent receivable. But, yeah, so if a borrower doesn't or a tenant doesn't pay it, then that would be put on non-accrual or we'd reserve against a rent receivable. We haven't experienced that yet in the lease-up period.

And then what's the current headcount at AAIC, please?

Ten as of today.

Keep in mind, Chris, as it relates to the rent question, keep in mind that underlying rent growth in each of the markets that we're involved in is quite high. The appetite for access to rental properties by renters is extremely high. That appetite is extremely strong. And as we all know, rent growth is quite significant. So it's not impossible that we would end up, certainly not impossible, it's quite possible we may end up with a house where the tenant doesn't pay, but it's not a very difficult thing to replace them with someone who's willing to pay that rate or even more because these rents are going up on sort of a monthly basis.

Sure, unless they take you to landlord-tenant court, Rock. And then, you know, as a landlord, you are a distinct disadvantage in many municipalities.

Well, we're pretty careful about the jurisdiction. We're very careful about the jurisdictions we're in, Chris, very.

All right, and then going forward, how should we look at operating expenses for the company, please?

As I said before, we've had success in reducing those levels fairly significantly in the last two years, but I'd say from here that's going to be more challenging. It's just a kind of environment where that's more difficult. So I would say something that's reasonably flat, maybe up or down a touch, but something that's in the neighborhood of reasonably in line with 21 is probably a fair number. We keep working at the notion of knocking it down, and who knows, maybe a year from now I have a different answer, which is that we've been able to successfully reduce expenses again. I don't want to leave that expectation. I think flat or a little up or down is reasonable. Great.

Thank you.

Thank you. Our next question comes from Mikkel Goberman with JMP Securities.

Hi, good morning. Hi there. Hi, Rock. Apologies if you touched on this in your prepared remarks, but I'm wondering, could you give a breakdown of how you're allocating capital in light of all the recent and current market volatility vis-a-vis all of the new silos that you're investing in?

Well, what we said was about 43% at the end of the year is in MSRs. I would say that's probably not a lot different today than year end. We're ramping toward 50, and at SFR we're not there yet, but we're 50 million, yeah. Oh, 50 million, yeah. We're ramping toward 50 million, so, you know, call it 15, 16%, 17% there. Credit probably has another 10%-ish, maybe a little higher. And the rest is agency. And the overall agency portfolio carries, naturally, because it has a significant capital base and not a large balance, it carries leverage that I think we noted was in about four, something like that. So the rest of the capital. And it's in the investor presentation as well. You can see both the asset allocation and the capital allocation. I think it's page 12, is it? I may be wrong about that. It's in the investor presentation. But that's sort of it. You know, sort of 45 ultimately fully ramped. The SFR will be about 15 to 17. And credit is, you know, 10 or 12, something like that. The rest today is agency.

So nothing materially different since the end of the year. No.

Growth in SFR as we ramp up the portfolio and probably a corresponding decline in the agency side.

Yeah, exactly. I mean, if there's a specific question you're trying to get at, go ahead and ask it. But I guess it's fair to say Rich's comment I think is accurate, and it's fair to say that our cautious view on agencies has not changed. despite the fact that they have widened by 30, 40 basis points at least, you know, our cautious view there has not changed. So we are keeping that portfolio at a relatively muted volume and leverage accordingly and favoring other asset classes with more resilient characteristics, in our opinion, in these market conditions.

Great. Thanks a lot, guys. Appreciate it.

Thank you, Mr. Tonkle. There are no more questions at this time.

Okay. Well, thank you, everyone. Please feel free to call additional questions, and we appreciate your time and support. Thank you.

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.