Arlington Asset Investment (AI)
Q4 2012 Earnings Call
February 07, 2013 9:00 am ET
Kurt Ross Harrington - Chief Financial Officer, Chief Accounting Officer, Executive Vice President and Treasurer
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David M. Walrod - Ladenburg Thalmann & Co. Inc., Research Division
Jason Stewart - Compass Point Research & Trading, LLC, Research Division
Good morning. I'd like to welcome everyone to the Arlington Asset Fourth Quarter and Full Year 2012 Earnings Call. [Operator Instructions] I would now like to turn the conference over to Kurt Harrington. Mr. Harrington, you may begin.
Kurt Ross Harrington
Thank you very much. Good morning. This is Kurt Harrington, Chief Financial Officer of Arlington Asset. Before we begin this morning's call, I would like to remind everyone that statements concerning future performance, returns, leverage, portfolio allocation, plans and steps to position the company to realize value, 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 factors include, but are not limited to, changes in interest rates; increased cost of borrowing; decreased interest spreads; changes in default rates; preservation of our net operating loss and net capital loss carry-forwards; impacts of regulatory changes and changes to Fannie Mae and Freddie Mac; actions taken by the U.S. Federal Reserve and the U.S. Treasury; availability of opportunities that meet or exceed our risk-adjusted return expectations; the ability to effectively migrate private-label mortgage-backed securities into agency mortgage-backed securities; ability to realize a higher return on capital to make future dividends; the failure of sovereign or municipal entities to meet their debt obligations or a downgrade in the credit rating of such debt obligations; ability to generate sufficient cash through retained earnings to satisfy capital needs; changes in mortgage prepayments fees; ability to realize book value growth through reflation of private-label mortgage-backed securities; the realization of gains and losses on principal investments; available technologies; competition for business and personnel; and general economic, political, regulatory and market conditions. These and other risks are described in the company's annual report on Form 10-K and quarterly reports on Form 10-Q, that are available from the company and from the SEC. You should read and understand these risks when evaluating any future-looking statement. I would now like to turn the call over to Eric Billings for his remarks.
Eric F. Billings
Thank you, Kurt. Good morning, and welcome to the fourth quarter earnings call for Arlington Asset. I am Eric Billings, Chief Executive Officer of Arlington Asset, and joining me on the call today are Rock Tonkel, President and Chief Operating Officer; and Brian Bowers, our Chief Investment Officer. Thank you for joining us today. I know it's a particularly busy couple of days and weeks for you, so we do especially appreciate it. 2012 was an important year for Arlington. Two accretive offerings during the year helped the company generate an ROE from core operating income of approximately 20% for the third consecutive year. Capital grew by 65% over the course of the year. Recurring expense burden on capital declined by 35%. Prepayment protection in the company's agency mortgage-backed security portfolio delivered single-digit CPRs and permitted cash net interest income to grow by 38%. Improving credit performance and high CPRs in the non-agency mortgage-backed securities portfolio generated an 11.5% current yield based on ending market value from the portfolio for the year and positioned the company to realize substantial appreciation from the housing recovery, and the company utilized $57 million in tax benefits during the year.
Finally, the company's complementary and balanced capital allocation permitted the portfolio to respond well to fluctuating market environments over the course of the year while generating attractive cash returns. Going forward, the company is well positioned to continue to deliver attractive cash returns plus growth.
Accordingly, during the fourth quarter, the company recognized an income tax benefit of $12.22 diluted per share, resulting from the release of $162 million in valuation allowances on its existing deferred tax assets. Going forward, the company will continue to receive the cash tax benefits of its $230 million net operating cash loss carryforwards through 2025, as well as a portion of its $285 million net capital loss carryforwards through 2014. Due to the company's current C corporation structure, shareholders will continue to benefit from an after-tax yield on the company's dividend that is approximately 35% higher than companies with a REIT structure. We continue to see encouraging performance from both our agency and non-agency portfolio. In the agency portfolio, all of our assets were specifically selected for prepayment protection of some type. Approximately 60% of our portfolio was originated under HARP programs and our remaining assets consist of either low-balanced loans, low FICO loans, high LTV loans or loans with other prepayment protected features. These loan characteristics significantly reduced the economic incentive to the borrower to refinance or constrain the borrower's ability to refinance. This quarter, our agency portfolio demonstrated the value of asset selection with a portfolio CPR of 6.1 versus CPRs of 34 on Fannie Mae 4.5% universe. For Arlington, the concentration of our portfolio in prepayment protected mortgage-backed securities with low CPRs has a significant positive impact on the consistency of our asset yield and spread income, as well as on the preservation of book value. The futures contracts we utilize to hedge our agency portfolio run consecutively on a quarterly basis beginning in September 2013 and extend out to December 2018. They have an average notional amount of approximately $830 million. Based on book value per share of $35.24 at December 31, 2012, the mark-to-market average cost over 5 years of the hedge was 1.12%. Using the average hedge cost over its 5-year life, economic earnings going forward on a per share basis would be approximately $0.13 per quarter lower than core operating income per share in the fourth quarter, or $1.12 per share.