Armour REIT Earnings Disappoint Market

 | Oct 30, 2013 | 12:30 PM EDT
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The market punished Armour Residential REIT (ARR) Tuesday after a lackluster third-quarter earnings report, but I was somewhat surprised by the reaction. ARR management had previously reported the sale of $6.0 billion in Agency Mortgage Backed Securities (MBS) during the quarter which resulted in a net capital loss of $301 million.

This has been highlighted in their monthly updates -- specifically in the September 10 update, and obviously this needed to be fed through the profit and loss sector. Anyone expecting a "clean quarter" was not paying attention.

It was dirty: ARR's minuscule Taxable REIT Income for the quarter -- $3.8 million -- wouldn't support ARR's quarterly preferred dividends (Series A and Series B), let alone allow for the payment of a common dividend. But TRI is basically an IRS construct, and ARR -- and its shareholders -- have benefited in prior quarters from the inclusion of capital gains in that figure. Obviously, the July-August fire sale produced losses, which reduced that figure this time.

A more reliable figure for ARR is core income, which ran at $40.3 million for the quarter, a decline of about 35% sequentially.  I expect ARR's core income to improve materially in the future as the biggest operating issue for ARR in the quarter was an increase in cost of funds to 1.36% vs. an average of 0.94% for the trailing 12- month period. This is despite a decline in prepayment amortization to an annualized 0.53%, a huge sequential decline. That is less than half of the first quarter's prepayment amortization cost.

Why did cost of funds increase when prepayment costs are confirming the death of the mortgage refi boom? Remember that ARR bought $5 billion of interest rate swaptions during the month of September. Those swaption contracts obviously come attached with premia, thus explaining the jump in ARR's cost of funds. But like any type of option, that protection is now in effect. So there is no need to for ARR to continue to incur major expenses until those contracts are exercised or expire.

ARR has the right, but not the requirement, to enter into 5- and 10-year swaps with average interest rates of 2.73% and 3.16%, respectively. Most of the swaptions have a remaining life of 12 months, and obviously interest rates could change materially in that time frame.

But the massive swaption purchases are another indication of ARR management's "bunker mentality". This management team has reduced its balance sheet by 20%, bought expensive coverage against an interest rate shock and is still not buying back common stock. ARR's book value destruction this year has been a less than pretty sight, but one has too look at the financial positioning of the "new" ARR. With the portfolio largely -- 97.7% -- hedged and Agency MBS prices having recovered, the question is "where is the shock?"

 From a preferred shareholder's standpoint (which we are, in the form of ARR's Series A) each of those "bunker" actions, at the margin, increase creditworthiness. This certainly comes at the expense of short-term profitability -- and common dividends. That is the reason that Portfolio Guru, LLC has chosen to write call options against its ARR long positions.

Watching a management team partially "unwind" a company in an overall market where expectations of growth are paramount can be frustrating. But this is a situation where one wants to be a creditor of a company whose portfolio consists entirely of U.S. government-guaranteed assets.

The bottom line is that ARR's book value at quarter end was $5.26, a substantial premium to the current ARR share price of $4.10. At a 22% discount to book value, there is some downside limitation in ARR common. Some of the doomsday scenarios ARR management has hedged against are just not likely to happen. I don't see a quick Fed taper (we'll find out more this afternoon on the Fed's current worldview).

The move in the 10-year U.S. Treasury rate back down to 2.5% from 3.0% shows the bond market's valid concerns about the U.S. economy. So, we'll keep buying ARR-A and enjoying the 9.2% current yield. That translates to a 9.6% APY, given the security's monthly payment profile.

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