Orchid Island Capital - Q3 2024

Transcript

Operator (participant)

Good morning, and welcome to the third quarter 2024 earnings conference call for Orchid Island Capital. This call is being recorded today, October twenty-fifth, 2024. At this time, the company would like to remind the listeners that statements made during today's conference call relating to matters that are not historical facts or forward-looking statements subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, belief with respect to future events, and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in such forward-looking statements. Important factors that could cause such differences are described in the company's filings with the Securities and Exchange Commission, including the company's more recent Annual Report on Form 10-K.

The company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions, or changes in other factors affecting forward-looking statements. Now, I'd like to turn the conference over to the company's Chairman and Chief Executive Officer, Robert Cauley. Please go ahead.

Robert Cauley (Chairman and CEO)

Thank you, operator, and good morning. Thank you for joining us. Hopefully, everybody's had a chance to download the slide deck so they can follow along with us. Just to kind of start, I will start off by going over our financial results for the quarter. Then I'll discuss the market developments that occurred during the quarter that shaped our performance and, and our decision-making with respect to the portfolio. Then we'll dive into the portfolio characteristics, what we did during the portfolio, how we positioned ourselves, and then our outlook. And then there's a substantial appendix. We have a lot of information, that is in the appendix that you can use. We won't necessarily go through that. That's just for your reference.

With respect to our financial results, for the third quarter of two thousand and twenty-four, Orchid had a net income of $0.24 per share. That's versus a $0.09 loss during the second quarter. Book value declined modestly from $8.58 to $8.40. The total return for the quarter was positive 2.1%. That's not an annualized number, and we declared three $0.12 dividends. The portfolio, these, these are average balances, did increase quite a bit during the quarter. I'll have more to say about that in a few minutes. The leverage ratio did expand slightly. That's predominantly just because of a slight tweak to the amount of TBAs that were short and a modest book value decline.

Speeds increased modestly during the quarter from 7.6 to 8.8, with the rally in rates, and our liquidity is relatively in line, up slightly, versus where it was in the second quarter. Slide 7 just has our financial statements. I'll leave those for you to review. I'm not going to go over those. We'll be releasing our 10-Q later today, so you can have a much more in-depth dive into our financials at that time. Now, turning to the market developments which shaped our results. Just to kind of start, if you look back to where we were at the end of the second quarter, things were looking quite well for the mortgage market and for REITs in general. Most of the data that the Fed paid attention to, inflation data and labor data, was trending down.

Most people were anticipating substantial Fed eases, and in fact, we got one, a fifty basis point cut in September. The curve was steepening and, the IOs were expanding in this space, and the outlook was quite good for mortgages. With Fed reducing rates, the curve steepening, potential for banks to come in in a more meaningful way, things looked quite good. That was until late in the quarter, and things did change. As you are well aware, late in September into October, we got some data that was kind of consistent with a quite robust and resilient economy. Certainly not one that appears to be headed into a recession anytime. It's quite resilient. We may have a, you know, soft landing, no landing, who knows?

But it's certainly not as dire as it looked just a few months ago. And then most recently, as we approach the election, which is, of course, a big wildcard for the markets, it appears that the market may be pricing in some probability of a Republican sweep. The significance of that is kind of twofold. Traditionally, Republican administrations tend to be more pro-growth. So to the extent the economy is not as soft as we had thought and may be much more resilient and growing, that would, of course, add to that growth. And then the second one would be just based on President Trump's pronouncements, that they tend to be kind of consistent with an expanding deficit, and, you know, that would, of course, put some upward pressure on rates as well.

We're in this transition period now, since the end of the quarter. There's a lot of uncertainty in the market at the moment. We don't know how the election's gonna play out. We really don't know just how the economy is going to evolve. It looks at the moment as if it's gonna be resilient and strong. GDP data comes out next week, so we'll get to see, but it looks like it's somewhere around 3%, so it's not a weak economy, and that means that rates are probably not gonna be rallying any meaningful amount anytime soon. If you look on page nine, you can see that the red line was where we were at the end of the second quarter.

The green line there on the top left is where we were at the end of the third quarter, and the blue line was as of last Friday. We are higher than that today. Rates have continued to sell off, although the last two days been some kind of a stabilization there. And then the spread on the bottom, you can see it, has moved as we steepened, but still has a long way to go from what would be more traditional levels. Turning to slide 10. This is just the spread of mortgages to the 10-year Treasury, the current coupon mortgage. And you can see, this is a 10-year data range here, so it's kind of hard to pick this out. But if you look at the extreme right, you can see the downward sloping portion of that curve. That was Q3.

We had a very good quarter going on, as I said, until about mid-September, and we've since reversed. This number here on this table says one hundred and thirty-two basis points. That number is now north of one hundred and forty-two this morning. So quite a reversal. With all the uncertainty in the market, people are just not buying mortgages in any meaningful way. We generally have widening pretty much every day. Monday of this week was quite severe, and until this uncertainty is resolved, it's just kind of a tough market for rates and for mortgages in particular. Other spread products don't seem to be as affected as mortgages are, but it hasn't been a pretty run for mortgages of late. The bottom left, page 10, shows you this is normalized prices for select coupons.

And again, this data is through last Friday. If you were to update that, those numbers would be closer to the hundred line, meaning that, that these coupons have given up a fair amount of the gains that they enjoyed during the third quarter. Roll activity is somewhat better in the higher coupons, not so much in the lowers, but generally, rolls are a little bit better than when we last spoke. Moving on to volatility, obviously, a very important driver of mortgage performance. You can see on the far right side of the page that, we've been trending higher. If you were to update this one again through today, it's still higher, yet, up close to one hundred and thirty on the MOVE Index. And we've got meaningful events on the horizon. We've got a Nonfarm Payrolls report next Friday.

We have the election on the fifth, and then the Fed on the seventh, and you know, whatever else comes data-wise after that, so I would say the outlook for volatility in the near term, at least, is to remain elevated. I don't expect to see that fall, and that's generally not good for mortgages. Slide 12 just gives you some picture of refinancing activity, and you can see we did have a bump. Either the top left or the bottom right, you do see that small bump, but it could be that was a short-lived phenomenon. During third quarter, prepayment fears became very real. Spec pool pay-ups did benefit from that. People were really concerned about prepayment risk, but as of now, that's really not so much the case.

And it remains to be seen who and how this plays out going forward, but for the moment, those fears are clearly abating. Slide thirteen, I just kind of leave this for your perusal. One of my favorites. These numbers here, the blue line is just the GDP of the United States in nominal dollars, nothing more, and the red line is the money supply. As you can see, for 10 plus years, growth, which would be represented by the slope of the lines, of the blue line, was incredibly stable. But since the pandemic, we've seen the money supply expand far above its trend growth line, and GDP has as well, cause and effect you could debate.

But I don't think there's any doubt that with the current level of deficits, the fact that money supply is elevated and we're seeing elevated growth levels and consumer spending, it's possible that there is, and to the extent that continues, it's really hard to see the economy weakening materially. And so, what that means for rates remains to be seen, but I don't see it being supportive of a big rally. Now, that's kind of what's happened in the market. Now, I'll just kind of turn to what we've done, how the portfolio has been repositioned, and how we've positioned ourselves going forward. So we had the Fed pivot. We've been waiting for this for a long time. We finally got it. Not so much sure how much we're going to get of additional Fed easing. May not be much.

That being said, we did raise $110 million to our ATM in this quarter. That represents a 20% increase in our share count. And by deploying those proceeds, we grew our portfolio likewise by about 20%. So a pretty substantial growth for the quarter. And the way that we did that was basically acquire higher coupon mortgages. We've talked about in the past how we wanted to build out a barbell portfolio. Now we have fully done so. In fact, now the portfolio has a very much up in coupon bias. So the proceeds were deployed in the 6%, 6.5%, and 7% coupons.

The result of that was to raise our weighted average coupon by 22 basis points from 4.72 to 4.94, and the yield on the portfolio expanded by around 38 basis points, 505 to 543. Now, one thing being said is when we deployed these assets, most of this was front-loaded in the quarter to a large extent. We hedged those with predominantly longer duration swaps, 7 and 10 years. And as a result, with the rally during the quarter, we kind of underperformed. And that's just a result of the fact that with the rally in rates, our hedges, which were, as I said, longer tenor swaps, combined with assets that were shorter duration assets, which rallied, I'm sorry, that which widened during the quarter as a result of prepay fears.

That didn't do as well during the quarter. That being said, since quarter end and rates selling off, it's probably allowed us to outperform a little bit. So I'll say more about that in a moment. But so that's basically what happened with respect to the assets. Page 16 just shows you this in pictures. We've added upper coupons. Now, you can kind of clearly see on the far left that there's kind of a bias to upper coupons. But that being said, we have retained a substantial holding of discount securities, which have great convexity characteristics in the event the market does rally back. So the barbell is still in place. It just has an upper coupon bias. Now, with respect to funding, one thing is, you know, clear with the Fed ease, we had an immediate benefit of that.

It was roughly thirty basis points, which was felt in September. That's just more of an artifact of the fact that repos roll, and so we don't get the immediate fifty basis points, but it has allowed our funding costs to drop. They had been remarkably stable, as you can imagine, for some time. The data that's on this chart appears somewhat misleading. I don't want to dwell on this, but it says that, for instance, our average repo rate was 5.62 versus 5.34. That's very misleading. It's just an artifact of how we do this. As I mentioned, when we grew the portfolio this quarter, it was tending to be more front-loaded, so we had that extra interest expense load, if you will, for the quarter.

But the denominator in the calculation is just the average balance, and so the average balance is kind of low, and it makes it look like our funding cost is higher. That's really misleading. And I think as we have a period of slower growth or no growth, those numbers will, you know, normalize, and what you'll see is that our repo funding costs are lower than they were for prior quarters, roughly 40 basis points. But I do have to make one point, with respect to what we are seeing in the funding markets, and that is the fact that over quarter end, month end, year end, there has been some expansion in the spread.

So for instance, when we enter into a repo, it's a spread to Fed funds or a spread to SOFR, and those do expand over those periods. So there is evidence that funding pressures are emerging. From what we hear from the Federal Reserve and various members of the board, they don't seem to be concerned about that. What we do hear from the funding desks across the street is that there is clear evidence that's starting to happen. Nothing too acute yet, but it's definitely happening, and it does offset some of the benefit of the Fed cuts, at least over those periods. So on average, it's gonna eat into the 50 basis point easing or whatever additional easing we get by some amount.

The exact extent of that is remains to be seen, but, it's definitely out there. And, you know, the Fed is doing QT, and so there is being liquidity drained from the system. Dealer balance sheets are quite full. So we'll see how that plays out. Something worth watching. With respect to our hedge positions, really not much change. We continue to be heavily reliant on swaps. They cover a very high percent of our funding liabilities, and the combination of that with the migration up in coupon, which tend to be less rate-sensitive, securities, the portfolio is, you know, slightly more defensive than it was at the end of the second quarter. Slide 10 just shows you the details of our hedges. One thing we have done, I will point out, is in the top left, our SOFR futures.

We've been opportunistic with respect to adding these. Whenever we've gotten really bad economic data, which caused the market to rally and the market to price in more Fed easing, we put a bunch of those in to try to lock that in. And so, you know, hopefully, that has been... There is, you know, helps us in the future by kind of locking in some lower funding costs, because, you know, the market has generally been very aggressive at pricing in Fed easings and been frustrated when they don't appear, as expected. Otherwise, we did move some of our five-year future shorts into a five-year swap, and a combination of that and SOFR future shorts.

And the rest of the expansion, which again, is a product of the growth in the portfolio, we did add to some 7-year swap positions, another $100 million. Slide 20 just shows you expected returns across the coupon stack. This is something we're always looking at. I'm not gonna say anything about it other than just to point out that we have it. It does shape our decision-making. Slide 21 shows you our interest rate sensitivity, and you can see based on this, that there is a kind of defensive bias to the portfolio at the moment, just as a result of the things I just mentioned. And you can see that we do a little better in a rally or a sell-off, which is, you know, not typical, less in a rally, and that's just because of the positioning. Speeds.

You know, we did take on a lot of higher coupon exposure, but by selecting kind of lower quality spec pools and taking advantage of the newness of those securities and the fact that they don't tend to prepay rapidly, our speeds weren't that high. Our 7% speeds, you can see, had a high print in August, but the three-month speeds versus the prior quarter are not that elevated, and then when you consider that we've seen rates sell off and we're heading into the summer or the seasonal slowdown, it seems that these higher coupon securities that we add were likely to experience slower speeds, which means they're gonna have better carry, so the combination of higher coupons in the portfolio and higher coupons that are prepaying slower should be beneficial for the yields that we realize.

And as I mentioned, we have a slight improvement in our funding costs, so there has been some benefit to our NIM that we expect to realize going forward. Modest, but some. So just kind of to summarize, looking back, looking forward, as I said, we did get the pivot, but it may not be what the market was hoping for. It may not be the extent of easing that we had hoped or expected not too long ago. That being said, we have continued to both employ our barbell strategy, but now with an up in coupon bias, which I think is well suited for the market conditions today. And the market for arguably two years now has continued to overestimate the weakness in the economy and the extent and timing of Fed rate cuts.

We really just haven't seen those play out. And, in the fourth quarter so far, as a result of these developments, you know, mortgage spreads have given back a fair amount of what we had gained in the third quarter. But that being said, we're very comfortable with our positioning and our hedge structure. We think we have some modest NIM expansion here. And as I said, there's a lot of uncertainty in terms of where we go from here. But to the extent that rates do continue to back up, you know, we do have a very high-yielding portfolio. We might be able to continue to maintain that yield, therefore dividend level, with potentially less leverage if this continues, just because of that NIM expansion. So, that's kind of like it for the quarter.

That's how we see things evolving. And, with that, I think we can turn the call over to questions, operator.

Operator (participant)

Thank you. At this time, we'll collect the question-answer session. To ask a question, you'll need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one again. Please stand by while we compile the Q&A roster. Our first question comes from the line of Jason Weaver of JonesTrading. Your line is now open.

Jason Weaver (Analyst)

Hey, good morning. Thanks for the time. First, Robert, you touched on this during your remarks, but taking into account the thirty years that you bought in the sixes and up into the sevens and the short TBAs and low coupons, does this reflect a view that you expect little relief in benchmark mortgage rates over the next twelve months? And does it change the favorability of the barbell strategy at all going forward?

Robert Cauley (Chairman and CEO)

We do have a bias to a higher coupon. It's hard to have a firm view on rates going forward, just because the data just tends to be so volatile, and as we saw in September, you can get whipsawed. I would say one thing we kind of think, though, is that if you look at where rates are and where they can go from here, there's certainly for them to go higher. To the extent the economy is stronger or inflation reemerges, deficits keep growing, they can go higher. I don't see the potential for rates to go the same magnitude lower. Let's say that we're totally amiss here, and the economy is gonna go into a recession, and the Fed is gonna cut to... the funding level is gonna go to neutral, whatever that is.

I mean, we don't even know what that is. If you look at the dot plot, that could be two and a half to three and a half. Let's say it's three. If they were to cut to three, where do you think the rest of the curve shakes out? I mean, the 10-year in that scenario shouldn't be much less than four, and we're a little over four now. So it, the outlook going forward, I think, is kind of asymmetric. So that's why we like this kind of up in coupon bias. But because of the uncertainty, we don't want to just throw in the towel on lower coupons because we saw in the third quarter, you can have a rally, and the higher coupons will underperform. You want to add to that?

Yeah, the lower coupon strategy is, you know, nothing to write home about during times when spreads are relatively tight. They, you know, they do have lower yields, lower carry for the portfolio. But when we get in environments like now, where, you know, I'd like to look at mortgage spreads versus, you know, current coupon mortgages versus sevens or ten-year swaps, and you know, we're getting back to the wides of the year. And so, now is the time when we really like to have those on. In the event rates turn around and rally and spreads tighten, we would expect the most spread duration positivity out of those, where the higher coupons are going to underperform again into that rally.

So, we have intentionally had a sort of a more conservative bias, I guess, and felt like the economy is very strong. As Bob alluded to earlier, we've opportunistically tried to lock in the aggressive amount of Fed rate. At one point, I think we were pricing in six or seven Fed cuts over the next nine to 12 months. We're pretty opportunistic about locking those in via SOFR futures. And so we like our positioning. It wasn't looking all that great for us through the third quarter, but now rates have turned around and sold off and widened. And so, you know, we feel like the strategy is continuing to work.

Jason Weaver (Analyst)

Got it. That, that's helpful color. And then on the same dimension, on the other side, looking at the swap position, it looks like your hedge ratio actually came down a bit, even though, you know, dollar duration is not that much changed, coming into September. Any color you can give us there regarding sort of risk appetite into year-end around the election? And any comments, you know, about the... You made some comments around expecting volatility ahead in the next few months.

Robert Cauley (Chairman and CEO)

Yeah, well, we did add to this. We grew the portfolio by 20%, but our swap positions did not grow by that amount. That's where we added to the SOFR futures, trying to lock in some of that funding. We've seen a lot of movement in swap spreads on the front end of the curve, which kind of offsets the effectiveness of those hedges. And volatility, you know, it's really hard to see that dying off anytime soon. And, you know, as long as that stays elevated, mortgages are going to not perform well. Going forward, it's hard to have a lot of conviction in anything. You know, we were at a conference earlier this summer, and Kevin Warsh was speaking, and you may recall, he was a Fed governor, quite a bright lad.

And he made the comment about economic data. Basically, his point was that the, that data has no business having any numbers to the right of the decimal point. In other words, what he meant was it's very inexact science. And he says: "I know every one of you guys out there in this room are, you know, waiting with bated breath for the next Nonfarm Payrolls number." But he said, "They're not really good at this stuff, and it's probably going to get revised multiple times." And, you know, it, it is very much economics is the inexact science. And, you know, it's really just in this year, we've seen so much volatility in data, data being revised, GDI, Gross Domestic Income, revised up the savings rate and revised up by 200 basis points. Just causes a lot of volatility.

And, you know, we have a data-dependent Fed. So we have a Fed that's making all their decisions based on data that's extremely volatile and subject to revision. So it's really hard to see volatility remaining low. And then the election, you know, it's been chaotic, to say the least. Who knows? It's a toss-up. We don't know who's going to win. We don't know who's going to control the House or the Senate. We don't even know when they're going to finalize the results. So it could be bumpy for a while.

Hunter Haas (Chief Investment Officer)

Yeah. With respect to the profile of the portfolio, I think that just reflects a little, you know, we try to not be myopic about quarter to quarters, and, you know, have a little bit of a house view and lean one direction or another. We were very much in the camp of, you know, rates seem to have come down really fast. And, but at the same time, you know, we have to make adjustments and delta hedge as needed when hedge ratios were coming way down. So we did trim some hedges into the rally, and we haven't reversed course quite yet.

So, we're just really trying to fine-tune more than anything. I wouldn't say it's reflective of any change in our core position. But, you know, mortgages start getting shorter whenever we have big rallies, and we got to make sure we don't get too far offsides with respect to how the portfolio is hedged.

Jason Weaver (Analyst)

Got it. Thank you for that, and congrats on the quarter.

Robert Cauley (Chairman and CEO)

Thank you.

Operator (participant)

Thank you. One moment. Our next question. Our next question comes from the line of Mikhail Goberman of Citizens JMP. Your line is now open.

Mikhail Goberman (Analyst)

Hey, good morning, guys. Hope everybody's doing well.

Robert Cauley (Chairman and CEO)

Good morning.

Mikhail Goberman (Analyst)

Bob, good morning. Your recent statement just now that going forward, it’s hard to have a lot of conviction in anything, I think can be applied to a lot of things. So I think that’s very much on point there. If I can start with just an update on book value. I know you guys mentioned that you might have outperformed a bit since the end of the quarter.

Robert Cauley (Chairman and CEO)

Yep. We calculate an estimate every day, and as of yesterday, we were down 3.7% quarter to date. The last-

Mikhail Goberman (Analyst)

I'm sorry, up three point?

Robert Cauley (Chairman and CEO)

No, no, down 3.7%.

Mikhail Goberman (Analyst)

Yeah. Got you. Okay.

Robert Cauley (Chairman and CEO)

Most of that's occurred in the last five or six days.

Mikhail Goberman (Analyst)

Got it. Thank you very-

Robert Cauley (Chairman and CEO)

The spread widening just in the mortgage market has overwhelmed the positive effect of our slight duration bias.

Mikhail Goberman (Analyst)

Right. Right. Just looking at your prepared remarks in the press release, the statement here that you continue to view a bear steepening of the yield curve as the greatest risk to the portfolio. If I could just maybe drill down into your thoughts around that. If that situation were to come to pass, how would that affect your portfolio construction as well as the hedge portfolio?

Robert Cauley (Chairman and CEO)

Well, I think the, as I said, the bear steepening and extension of mortgages, especially the higher coupons, we have a higher coupon bias, so the fear would be if you get a big bear steepening, those premiums, or not even big premiums, two, three-point premiums, all of a sudden start drifting down the price range and become discounts potentially, so they can extend. That's why the hedges were, you know, a lot of seven and 10-year swap hedges. But I also think with the modest improvement we've seen in our NIM, that we could try to take the leverage down some and maintain that yield. And we already, you know, we have one of the highest yields in the space, as you know, so it's not like we need to stretch to expand that.

We have no reason to do that, and, especially given all the uncertainty that's out there. So if we could pay the same dividend yield and have less leverage, that would be desirable, especially if we do see that bear steepening. You know, in the rally, as we mentioned, you know, it was kind of... The reason the market rallied was more in anticipation of something that didn't happen. Had that happened, like, let's say, the next three months of data were horrible and the Fed were going to ease aggressively, then well, that's going to change our outlook and positioning. But we didn't see that, and so we're, you know, that's why we still see the risk as, of a bear steepening as being the most, you know, severe.

Mikhail Goberman (Analyst)

Gotcha, and just kind of piggybacking on that leverage question, economic leverage, 7.6 at the end of the quarter. I see that with respect to your comments just now, maybe drifting to a six handle if a situation like that arose?

Robert Cauley (Chairman and CEO)

Yeah, the way we've done that in the past, generally is, you know, not so much outright selling. It's usually a combination of adding TBA shorts and/or not investing pay downs, just to let the portfolio shrink a little bit. And, you know, depending on how it played out, if it was sudden and violent, there's usually nothing you can do. It's usually over before you know it. But if it is a slow grind higher, that's how we would approach it.

Hunter Haas (Chief Investment Officer)

We have some cushion with them, particularly in the 6, 6.5, and 7% buckets of the... You know, I think that those will continue to do well. You know, it's been a little bit frustrating for us because those particular coupons underperformed into the rally of the third quarter and have not really reversed course into the sell-off. I think that's just you know due to the uptick in volatility and uncertainty. So, we still like the strategy, even though those particular coupons aren't really ripping like we would have expected them to into a sell-off. I think that there's a good chance we get past some of these, we get some of this uncertainty behind us, and we'll start to see those firm up.

If rates stay at current levels, those will be great assets to own. The carry will be fantastic on them.

... And I think what Bob's alluding to in this bear steepening, being a, you know, the worst case sort of for the portfolio, is one where we blow through even, you know, going back towards 5% on tens and, you know, but it's gonna be a substantial move. So we feel like we have adequate time to prepare for that. It's gonna be a, probably a grind as opposed to a quick shock. So, we'll be watching and then reacting.

Mikhail Goberman (Analyst)

All right. May we live in interesting times. Thank you, gentlemen. Good luck going forward.

Robert Cauley (Chairman and CEO)

We certainly do. Thanks, Mikhail.

Operator (participant)

Thank you. One moment for our next question. Our next question comes from the line of Jason Stewart of Janney Montgomery Scott. Your line is now open.

Jason Stewart (Analyst)

Hey, thanks, guys. Clarification on repo-

Robert Cauley (Chairman and CEO)

Hey, Jason.

Jason Stewart (Analyst)

How you doing, Bob? Clarification on repo cost at quarter end. The five twenty-four number was an average. Could you give us quarter end, or was that, did I misunderstand that?

Robert Cauley (Chairman and CEO)

No, the quarter end, the actual average as of that date was 5.24, and then would have been coming down. We grew so fast and the growth was so front-loaded. The way we present that number in there is, John, you just take the total interest expense divided by the average balance. And since the balance grew by 20% for the quarter, I think the average repo balance was a little under $7.8 or $4.8 billion. But in fact, our repo balance was north of $4.8 billion at the end of July. So the interest load was for more of a quarter, so it makes it look like our average repo expense is higher, but it's been stable.

I mean, you know, the Fed hadn't moved for months and months, so we were running somewhere in the 5.5 range, and then it came down about 30 basis points in September. We did have, as I mentioned, funding spreads were elevated over quarter end, but we'll get more of that in October, November, and then we'll see what year-end brings. There's, so, you know, it's down 30-40 basis points, depending on the day you look at it, consistent with Fed easing 50 and spreads on average, a little higher than they had been because of what appears to be some tightness in funding. We'll see how that plays out.

As I mentioned, you know, when you speak the head of the San Francisco Fed, I think it's Lorie Logan, who used to run the SOMA desk. You know, in her mind, that there are no issues and that they should ignore any talk from the markets that these things exist and that they're going to continue full ahead, steam with QT. That's not consistent with what we hear from people who live in the repo funding markets day in and day out. There's balance sheet constraints that are out there, you know?

Jason Stewart (Analyst)

Yeah.

Robert Cauley (Chairman and CEO)

It's just to give some context to that, too, whereas we were maybe funding it, you know, anywhere 14-16 over SOFR, you know, for several months, that's gapped out and maybe is pushing 18 or 20 now. We'll see. You know, of course we're watching and those things could change, especially coming into year end. You know, a handful of basis points right now, which is material, but where our book is resetting is basically high very high fours, low fives, as the new, you know, sort of Fed funds levels are you know going to impact our rolling repo positions. Let me just give you some added color on that.

Like, so like, let's say this week, the market expects a pretty high probability to cut in November and less so in December, but there's a lot of uncertainty around that, right? So if you look at the Fed Funds futures curve through the balance of the year, it's consistent with what you see on the WIRP screen, right? So you're gonna have something north of one ease, but you also know, for instance, that there could be some year-end funding pressure. So what would be a three-month repo today? It should factor in a combination of market pricing for certain eases and also maybe some funding pressure over year end. And if you go out and talk to dealers, you can get quite a wide range of levels that they're gonna offer you, all reflecting a combination of that uncertainty and their bias.

And, you know, that can be quite wide. We got that, you know, saw that as low as four eighty-eight and north of five. So that's-

Jason Stewart (Analyst)

Yeah.

Robert Cauley (Chairman and CEO)

Those are. That's what we're seeing.

Jason Stewart (Analyst)

Okay. Now, Hunter, that was the answer, you got it on the head there. So 18-20 over SOFR. I mean, I'm seeing GC, like 4.90, and 18-20 over puts you at 5, and with 25 days average maturities, I mean, you should have rolled most of your repo by now. So, like, the marginal repo going through the quarter now should be closer to that 5 level, and we'll see where it goes from here.

Robert Cauley (Chairman and CEO)

Yeah. Well, we've got a Fed meeting in a couple-

Jason Stewart (Analyst)

Yeah

Robert Cauley (Chairman and CEO)

A week or two. So, we'll see what happens. Market's still pricing in pretty good probability of 25 more. So, we'll see how that goes. And as we alluded to earlier, we've put a lot on that September contract coming into the fourth quarter. So I think we have, like, $900 million with at least 125 basis points of ease baked into the market at the time we put those on. Yeah.

Operator (participant)

In this year.

Robert Cauley (Chairman and CEO)

Yeah, and we're looking at seven, probably eighty now. Yeah.

Jason Stewart (Analyst)

... Got it. And the other question was just on where do you see marginal ROEs? I mean, if we look at, you know, 3Q was a relatively good quarter for mortgages, and when you look at pretty much any metric, you know, plus 2.2% total return, it looks like it's a 17.1% dividend on book at the end of the quarter, plus a cost to operate. So, you know, do marginal ROEs hit that level? How are you thinking about marginal ROEs in your mind relative to the dividend?

Robert Cauley (Chairman and CEO)

I think they're probably, they've expanded slightly. But as I said, we're not looking to push the dividend yield. So I would say they're, I don't have the number in front of me, it's gotta be very high teens. So you figure for our yield, we're five and a half versus, you know, something in the mid-twos. You know, you've got close to three hundred over on a, you know, hedged basis, depending on where you want to set your leverage. You know, we're not gonna be pushing it, so we can clearly get to those kind of high teen numbers.

Hunter Haas (Chief Investment Officer)

Yeah. But with the par coupon mortgages, right now, we sit, you know, hedging with ten years, you know, spread of one hundred and ninety some basis points over ten years, so for swaps. So that's definitely a high teen operating environment.

Jason Stewart (Analyst)

Just one more on that. I mean, how do you weigh, in your mind, the potential to sort of build book value, in the sense that, let's say we are at twenty and you're paying out seventeen, and so there is marginal growth in book, if you didn't pay such a high dividend payout, do you feel like you get credit for that dividend yield? Or do you feel like- how do you weigh the-

Robert Cauley (Chairman and CEO)

Yeah

Jason Stewart (Analyst)

... potential of retaining that capital?

Robert Cauley (Chairman and CEO)

That's actually a very topical discussion point with us and the board of late. It's possibly more so in 2025 than 2024. That was, you know, the last time we had this discussion, we were thinking we were gonna get more easing than it appears we are. The question, you know, do you retain that? Do you consider paying some tax? Our view generally is you don't get rewarded for that. If you pay a special dividend, they tend to get discounted. If you pay tax, nobody seems to care. It might, you know, not give you any benefit for that either, which tends to drive people to pay out what they earn.

But, you know, I think that especially if we're in a rising rate environment, you know, the extent we can retain any, it's something we'll give a very serious consideration.

Hunter Haas (Chief Investment Officer)

Yeah. I think we're gonna transition from an environment where we were slightly over-distributing to an environment where we're maybe under-distributing for a little bit, and then we'll have to make a decision into 2025 as to you know what to do to the extent that we have tax obligations. You know, a lot of this is stemming from the fact that our pay fixed swap rate is very low, and so it's already been marked to market for GAAP purposes, but for tax we are gonna have distribution requirements that we're gonna have to maintain. So I wouldn't expect a change anytime soon. As Bob alluded to, you know, I think we can let the leverage slide down a little bit and maintain the dividend rate.

And then at the end of 2025, we'll have to just take stock of where we sit with respect to our tax obligations and make a decision how we wanna handle, to the extent that we have some under-distributed throughout the year.

Jason Stewart (Analyst)

Okay. Thanks for the questions.

Robert Cauley (Chairman and CEO)

Yep, thank you.

Operator (participant)

Thank you. One moment for next question. Our next question comes from the line of Christopher Nolan of Ladenburg Thalmann & Co. Your line is now open.

Christopher Nolan (Analyst)

Hey, guys.

Robert Cauley (Chairman and CEO)

Hey, Chris.

Christopher Nolan (Analyst)

A follow-up to that previous question in terms of the yield and so forth. Bob, when you're talking to the board or when you're having discussions with the board, how do you guys tend to look at overall performance? Because the dividend yield is quite high, but the book value has been, you know, declining down as you guys

... you know, for various reasons, including hitting the ATM pretty hard. And just give a little color in terms of how you guys look at shareholder return.

Robert Cauley (Chairman and CEO)

We always look at relative total performance or total return. When we saw opportunities to grow the portfolio, we were willing to run the ATM. We did so with, you know, very modest discounts to book. And I think given where our returns are, it was very much justified. Obviously now that's not, you know, the case, so we're not gonna be using that. We, in fact, actually bought back some shares very late in the quarter when we traded down. But no, it's always total return on a relative basis. You know, there were times when we were anxious to grow the portfolio to gain scale, so we ran the leverage on the high end.

We had a high dividend, as you well know, one of the highest yields in the space, and that allowed us to grow and reach some scale. That's not so much the case now. You know, we were raising money in the ATM in Q2 and Q3 because, you know, we thought we were on the verge of a Fed easing cycle, potentially an aggressive easing cycle, a steepening of the curve, an environment where it would be very attractive for both book value performance and net interest margin. Not so much sure that's the case now. As a result, we'll pull back from that, even to the point of, as Hunter just alluded to, you know, maybe even looking at some under distribution.

So, so there was a time when we were more aggressive with our duration, our leverage, and the dividend to try to grow, but that's probably behind us for the time being and maybe for quite a while, we'll see... Now it's more of a defensive posture. And you know, in all cases, you know, the board would look at total return, but they also, you know, given what we were trying to do, for instance, as I just said, grow the portfolio and run the leverage on the high end, you know, with that caveat, they understood that. So to the extent we were running higher leverage than everybody else, and we got a violent sell-off, and we underperformed, you know, they, they're aware of that because they were part of the decision.

Christopher Nolan (Analyst)

Okay and thank you, and then also, Hunter, do you guys have an adjusted economic EPS number which includes hedge income and discount accretion?

Hunter Haas (Chief Investment Officer)

We do not. We did not put that in, that table in there. We found when we did it in the prior two quarters, that it tended to generate more questions than answers, and we've kind of gotten away from that, but I don't know if it's in the Q, which is coming out a little later today. Let me have that. If you call, I can try to get you that. I don't have it off the top of my head.

Christopher Nolan (Analyst)

Yeah, that'd be helpful. Okay, thanks, guys. Good show.

Robert Cauley (Chairman and CEO)

All right. Thanks, Chris.

Operator (participant)

Thank you. One moment for our next question. Again, as a reminder, to ask a question, you'll need to press star one one on your telephone. Our next question comes from the line of Eric Hagen of BTIG. Your line is now open.

Eric Hagen (Analyst)

Hey, thanks.

Robert Cauley (Chairman and CEO)

Hey, Eric.

Eric Hagen (Analyst)

Good morning. Hey, how we doing? So how do you guys think about the size of the proportion of the TBA position right now? And if mortgage spreads were wider, do you feel like that would potentially lead you to raise your leverage or adjust, maybe adjust the TBA? How do you guys think about that, toggling that position? Thank you.

Robert Cauley (Chairman and CEO)

It's also a question of where we do the TBA shorts. Might start considering moving those to the higher coupons, given that they may be the most vulnerable, as I mentioned, to a bear steepener. It was easy to do them with threes just because it's a, you know, those are fully extended, and those are pretty good hedge instruments. But I think as we're, you know, looking at our potential for a steepening curve or a steepener, a bear steepener, it might be more in the higher coupons.

Hunter Haas (Chief Investment Officer)

Yeah, we're always looking at the roll levels and implied funding to, you know, get a sense for, you know, if something's rich or cheap. There's been opportunities to sort of buy specified pools, hedge them with TBAs, and have the TBAs actually contribute a little bit to the earnings picture. We also like to look at, depending on where we are in the rate cycle, now that we're bumping up kind of to back towards the higher end, at the convexity of the stack and use the convexity of short TBAs, you know, to benefit us in the event we turn around and have a rally, you know, to build in a little bit of protection.

I think that's what Bob was alluding to about the upper coupons, finding something in the stack that has the worst convexity as we approach, you know, kind of the higher end of the rate range, so that if we do turn around and get, you know, some sort of a relief rally, it would help with the underperformance of the higher coupon mortgages, which are also going to have worse convexity in that environment.

Robert Cauley (Chairman and CEO)

And also, you know, we had a lot of three shorts on for quite a while, and that roll was very negative for a long, long time. So it's easy to put that on.

Eric Hagen (Analyst)

That's helpful color. I appreciate that. I actually want to ask you about the IO and derivative position. You guys have been pretty active there in the past. How do you see that position maybe getting toggled or adjusted going forward? And even the supply of agency derivatives in a, you know, in this environment, or if the shape of the curve were to change from here?

Hunter Haas (Chief Investment Officer)

It's interesting you say. We've been doing a lot of tire kicking, running a lot of different strats. I think in general, I don't love the profile of the, you know, the legacy, lower coupon IOs. They have good yields, but they're kind of a mess from a hedging perspective. We're sort of, or at least were, at the point where we did have some actual two-sided risk with some of the more recent production.

I have been, or we have been very hesitant about doing too much in IOs, especially in the really high coupon space, just because I think when, you know, if we ever get back to an environment where mortgage rates are, you know, pushing 5%, 5.5%, I'm not sure that the models are really dialed in for the refi explosion that's going to occur from the production that's been created over the last couple of years. So I tend to kind of think there's some uncertainty around there. Also, though, we have seen some fast speeds, particularly in Ginnie's space, and so there has been a cheapening there. So given all of what I just said, there are some opportunities, and we're looking. We just haven't jumped in quite yet.

And then, of course, this more recent sell-off is making it less compelling. But I think that, you know, over kind of the medium term, we'll look to opportunistically add when we can find the kinds of mortgage derivatives that have the profiles that we like. So something that is either a little bit in the money or kind of at the money and has some real upside so that we can use it to mitigate some of the duration of the portfolio, while simultaneously providing a little bit of yield.

Robert Cauley (Chairman and CEO)

There's still huge demand for floaters on the CMO desk.

Hunter Haas (Chief Investment Officer)

Yeah.

Robert Cauley (Chairman and CEO)

So there's inverses being created. And those were very popular, you know, a few months ago, with everybody thinking we were getting a big easing cycle coming. They've cheapened up, obviously.

Hunter Haas (Chief Investment Officer)

Yeah, we've looked at some inverses as well, and I think there's still a lot of Fed cuts priced into the next year. So I think there could be, you know, to the extent that the market reins on the Fed easing parade, there could be some vulnerability in inverse IO space, but they will definitely have their moment. You know, I just don't think it's quite yet.

Eric Hagen (Analyst)

Always really appreciate the great color from you guys. Thank you.

Hunter Haas (Chief Investment Officer)

Yep.

Operator (participant)

Thank you. I'm showing no further questions at this time. I'll now like to turn it back to Bob Cauley for closing remarks.

Robert Cauley (Chairman and CEO)

Thank you, operator. Thank you, everybody. To the extent anybody has any questions that come up after the call or, if you're just listening to the replay and didn't have a chance to ask a question, feel free to call. Chris, I know you probably want to give us a shout, try to get you that number. Otherwise, we look forward to talking to, you all again at the end of the fourth quarter. Have great holidays and, be well. Thank you.

Operator (participant)

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.