James Mountain - CFO Jeffrey Zimmer - Co-CEO, Vice Chairman, President Scott Ulm - Co-CEO, Vice Chairman, CIO & Head, Risk Management Mark Gruber - COO.

Trevor Cranston - JMP Securities Sam Cho - Credit Suisse Mike Widner - KBW Brock Vandervliet - Nomura Securities.

Welcome to the ARMOUR Residential REIT Second Quarter 2015 Earnings Call. [Operator Instructions]. I would now like to turn the conference over to Mr. Jim Mountain, Chief Financial Officer. Please go ahead, sir..

Thank you, Operator. And thank you all for joining ARMOUR's second quarter 2015 earnings call. By now, everyone has access to ARMOUR's earnings release and Form 10-Q which can be found on ARMOUR's website.

This conference call may contain statements that are not recitations of historical fact and therefore constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act.

Actual outcomes and results could differ materially from the outcomes and results expressed or implied by the forward-looking statements due to the impact of many factors beyond the control of ARMOUR.

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of ARMOUR's periodic reports filed with these Securities and Exchange Commission. Copies are available on the SEC's website at www.sec.gov.

All forward-looking statements included in this conference call are made only as of today's date and are subject to change without notice. We disclaim any obligation to update our forward-looking statements, unless required to do so by law. Also, our discussions today may include references to certain non-GAAP measures.

A reconciliation of these measures to the most comparable GAAP measures is included in our earnings release which can also be found on ARMOUR's website. An online replay of this conference call will be available on ARMOUR's website shortly and will continue for one year.

ARMOUR's Q2 core earnings were $47.7 million or $0.12 per diluted common share, covering common and preferred dividends for the quarter by more than $1.5 million. GAAP net income was $198 million or $0.55 per common share on a diluted basis. The biggest difference between these two measures is the unrealized gains on our interest rate derivatives.

ARMOUR does not use hedge accounting for its GAAP reporting, so quarterly results will always be influenced or in this case, even dominated, by fluctuations in the fair value of our open interest rate swaps. On the other hand, the quarter's negative mark to market on our agency securities flowed directly in stockholders' equity rather than GAAP P&L.

At June 30, 2015, ARMOUR book value was $3.96 per share or $1.15 above the New York Stock Exchange closing trade price that day. ARMOUR paid cash dividends monthly of $0.04 per common share in Q2 and in July which represents a dividend yield on average book value of 11.9% per annum.

Quarter end balance sheet leverage and liquidity remained essentially unchanged from last quarter. We also have purchased $1.6 billion of agency TBA securities for forward delivery. Those positions are treated as derivatives for GAAP purposes and show net on the balance sheet.

The related $9.3 million of drop income is included in the core earnings figures I mentioned previously. Earlier this month, SABRE Business Insurance LLC which is ARMOUR's wholly owned insurance subsidiary, became a member of the Federal Home Loan Bank of Des Moines.

We have begun to pledge securities and take advances from FHLB Des Moines, so that the bank's staff gets to know SABRE better and we can begin to make practical use of the unique opportunities which membership presents.

For example, we may take a portion of the liquidity that we currently carry in cash and invest it in securities deposited with the FHLB Des Moines for safe keeping. When that liquidity is needed elsewhere, we could quickly draw a cash advance while improving earnings in the meantime.

Finally, I want to remind the investors listening in about the 1:8 reverse stock split of ARMOUR's common stock. That will happen on Friday, July 31 at about 5:00 p.m. Eastern Time which is to say after the market closes tomorrow. At that time, every eight shares of ARR common will be converted into one share of common stock.

Any fractional shares resulting from the conversion will be redeemed for cash based on the average closing price from yesterday, today and tomorrow. As an example, a shareholder that holds 1600 shares of ARR in their account on Friday should see that converted to 200 shares in their account on Monday.

The reverse split will reduce the number of issued and outstanding common shares of ARR from approximately 350 million to approximately 43.75 million. The ticker symbol will stay the same, ARR, but our stock will have a new QSII number. Common stock dividends for August and September have been declared as $0.33 per share on a post-split basis.

This represents a 3%-plus increase over the dividend for July in Q2 which would have been $0.32 on an equivalent basis. ARMOUR's Board of Directors also increased the size of the company's stock repurchase plan.

Commencing Monday, August 3, with the effectiveness of the reverse stock split, a total of 9 million common shares will be authorized for repurchase under the program. Now, let me turn the call over to our Co-Chief Executive Officers, Scott Ulm and Jeff Zimmer, to discuss ARMOUR's portfolio position and current strategy.

Scott?.

Thanks, Jim. In addition to the customary SEC filings, we also provide a monthly company update which is furnished to the SEC and available on our website as well as EDGAR. The company update contains a considerable amount of information about our portfolio, hedging and financing on a timely basis.

As a result, the quarterly financial report we filed last night should contain no surprises to any of our equity analysts or shareholders. As shown in our monthly company updates from January 2014 through the present, our net balance sheet duration has ranged from a negative 0.46 to a positive 1.15 and is currently approximately 0.7.

Our rates DV01 or the dollar value of a basis point shift in the entire curve, is now approximately 1.1 million and our spread duration of an 01 in OAS move is approximately 8.2 million which does incorporate the fact that swaps could widen with mortgages making that number smaller.

Book value at the end of the Quarter 2 was $3.96 and we have a book value as of the close of business July 29, last night, of approximately $3.90 to $3.94. Last night's, Wednesday's, closing stock price of $2.70 is approximately 31% below this estimated book value.

This large gap between stock price and book value during Q2 encouraged us to buy stock back in the open market. The 1:8 reverse stock split of our common stock will be in effect on Monday of next week. Effective after the split, our Board has increased the stock buyback authorization to 9 million shares.

Our portfolio today is comprised of five major components. 34.2% of our portfolio is comprised of 15-year pass-throughs, of which 78.9% have loan balances less than $175,000. 30.1% of our portfolio is comprised of 20-year fixed rate assets, maturing between 181 months and 240 months, with a weighted average seasoning of 53 months.

15.9% of our portfolio is comprised of Fannie Mae multi-family bonds or DU.S., delegated underwriting and servicing, bonds which are generally locked out from prepayments for the first 9.5 years of their 10 year expected maturities. 7.9% of our portfolio is comprised of 30-year maturity fixed rates, of which 87.2% are $175,000 loan balance or less.

And 10.6% of our portfolio is comprised of 30-year Fannie Mae 3.5s on dollar roll. This portfolio has a lot of very convex assets and we expect it to provide good price performance in a rates rally and a limited amount of extension in a higher rate environment.

We have added a modest amount of higher yielding assets in the portfolio and slightly restructured the hedge book which together have increased our earnings. Our July core earnings estimates are equal to our dividend for July. While we have changed the composition of the portfolio, we have generally maintained notional swap position.

Today, 49.2% of our REPO refinancing is covered with $6.3 billion of current pay swaps. In addition, we have $6.4 billion of forward starting swaps that become current payers within 3 to 11 months. Our entire swap book has a duration of negative 3.9.

The size and tenure of our hedge book is expensive and part of the tradeoff of earnings versus book value protection. In periods where we perceive less rate risk, we would carry a significantly smaller and less expensive swap book. We continue to face spread risk, the variation in the value of MBS versus comparable tenure treasuries.

Changes in spreads can move valuation significantly, as they did this quarter. The good news is that spreads widen and tighten. The bad news is that it is difficult and uneconomic to hedge spread risk. It is also a major part of the risks be bear in order to earn our returns. The financing environment remains favorable for our business.

Although at the end of Q2, repo rates were a bit higher and some firms told us they wanted a smaller repo book at the end of the quarter, we continued to see wide availability of funding. ARMOUR has MRAs with 37 counterparties and is currently active with 28 of those. We actively seek to diversify our financing book.

Currently, our counterparties range from big Wall Street securities firms, to large European and Asian banks, to regional securities firms and some specialists. Details can be found in our monthly company update. We keep a close eye on our counterparties. While we're a secured creditor to them, they are an unsecured creditor to us for haircut amounts.

We have had numerous opportunities to extend our maturities to a year beyond in some cases. Putting some of this longer financing on the books depends on its pricing. We continue to feel that the U.S. economy is recovering and that improvement will be reflected in interest rates, despite the dissimilar environment overseas.

We have a positive view on the U.S. economic environment but remain mindful of the multiple factors impeding more rapid economic expansion. At the same time, we think the ultimate scale of rate changes, both on the short end and on the long end, is likely to be measured.

We believe that the rapid, sustained increases in rates we experienced in the past are unlikely to repeat, given the structural and other headwinds facing the U.S. and world economy. We do expect that the Fed will move to increase short-term rates at some point this year.

We remain wary of potential rate volatility across the curve, even if the ultimate extent of the rate changes are moderate. The experience of the second half of 2013 is ample demonstration of the potential volatility of the rates market, even with little ultimate change.

In our business, we feel the need to be prepared for a more difficult environment and that is reflected in our liquidity and rate protection profile. We have long maintained the view that we seek to balance earnings and book value protection.

In this environment, we have put our finger on the scale to favor protecting book value from higher rates as a long-term goal, yet while earning an attractive and sustainable dividend. We're pleased to have you as an audience today for our call and we'll entertain any questions you may..

[Operator Instructions]. And our first question comes from the line of Trevor Cranston with JMP Securities. Please proceed with your question..

I guess the first question, looking at the monthly updates, you guys had been adding some dollar roll positions to the portfolio earlier in the quarter and then in the July update, I guess it was pretty quiet.

Can you talk about what your current view is on dollar roll trades versus pools and where you're seeing the most value in the market right now?.

So as we've discussed before in our investment committee meetings, particularly the one we had earlier in the week, dollar rolls still are a pick of between 50 and 60, depending on how you look at it, versus going ahead and buying assets. The issue, though, is that they don't have the convexity.

For example, part of the book value decrease was not just the widening that took place in the second quarter, but as rates went up, the TBA dollar roll asset itself widens out and gets a little longer, whereas our specified perform well. So we'll still be mixed there.

I wouldn't expect to see that dollar roll position grow with any substantiality from where it is today, though..

And on the hedge side, obviously, the composition of the book has changed and there's a decent amount of forward starters in there now and it looks like there's roughly $2.4 billion that has a start date in about four months.

How are you guys thinking about that? Is the plan, in your current thinking, to allow those to become current pay swaps or would you anticipate rolling those into new forward starting positions when they hit that date?.

My answer is dynamic. We don't have to make a decision until we get there. I would tell you, at this point, all things being equal, we would roll them into further forward starting swaps to maintain a hedge against asset value changes rather than a hedge against our [indiscernible] exposure.

But some of these decisions are made within a week or two of the changes or of the maturities of those forward starting based on current conditions..

Right. Okay. And then last thing, on the FHLB borrowing capabilities, could you guys just talk about how you're thinking about FHLB funding versus the repo market and how you anticipate using it for your portfolio in the near term? Thanks..

Federal Home Loan Bank expert, James Mountain, will discuss that.

Jim?.

Sure. So we've only become, through our wholly owned insurance subsidiary, a member of Federal Home Loan Bank of Des Moines very recently. And so right now, we're in the sort of honeymoon phase of making sure we understand all the products that the Federal Home Loan Bank of Des Moines has to offer and exactly where they fit in in the portfolio.

As I said, one of the early strategies that we're looking at is reducing some of the cash cost of a liquidity event we've been carrying over the years by redeploying some of that cash into mortgage-backed securities that we can have on deposit and then within a few hours' notice, if we need cash liquidity someplace else, we can draw down and do that.

They also have a wide variety of funding options that go much further out into the forward time horizon than you'd normally see on straight repo and so at some point in the future, we might find that an interesting and attractive strategy as well. But right now, as I say, we want to walk before we start running..

But as Jim said, Trevor, we do have some modest borrowings, I believe it's $20 million on right now and we just started this and that will grow over time.

Now, you do have to buy stock in the Federal Home Loan Bank every time you increase your borrowing, so your haircuts are higher than we would typically have, however the rates are good and the borrowing source is very secure.

So we will use a good blend of that opportunity that I think will enhance kind of the soundness of our liability side of the balance sheet over time..

Our next question comes from the line of Douglas Harter with Credit Suisse. Please proceed with your question..

This is actually Sam Cho filling in for Doug Harter. So I've noticed that leverage has been trending up in recent quarters. I was just wondering if you're comfortable with the level and maybe your thoughts on how leverage is going to play out for the remainder of the year..

So our leverage is modestly higher than it's been, but not substantially higher and you'd expect to see it right where it is right now and not grow from there at all.

I would notice that during the quarter, if you look at our direct peers, despite our book value being down, I believe, 4.3%, it was the still the best book value performance of the released peers so far and our actually leverage is a little higher and in direct relationship with our hedge book.

So although leverage is an important indicator of potential risk to the volatility of the balance sheet, one must look to the amount of hedges and the duration of those hedges which are about negative 3.5..

Our next question comes from the line of Mike Widner with KBW. Please proceed with your question..

Let me just ask you a quick one about the prepay speeds. I see they picked up a little bit in July but remained relatively low compared to peers.

In thinking about that book, I guess the things I wrestle with are, you've got generally upward pressure from just seasoning, new stuff getting older will tend to prepay and then seasonality has been a lift, but we're on the other side of that kind of going in the next couple of months and rates are higher.

So even though prepays have picked up, there's an expectation they'll slow. What should we think about for the expectations or what are your guys' expectations for speeds on your portfolio overall and I guess, specifically, I'm wondering if the seasoning of the portfolio is going to outweigh sort of the downward pressure of the other stuff..

So let me address it in a number of different ways. Our 15-year pass-throughs, almost 80% of them have loan amounts of less than $175,000.

You'll get some modest seasoning increase there, but the reason that you buy those and you pay a little bit more over TBAs is because they don't have a big variability over time and it's been proven and all the dealers who trade in mortgages can tell you that. So that's a really good asset class right there.

And when we've had to reduce our assets due to leverage, we've been loath to sell those. Okay? The only way you'd see us sell more, if they get such a negative OAS that it doesn't look like a good hold for a period of time. But you wouldn't expect those to increase much over time.

Now, the 20-year portfolio doesn't have as much convexity in terms of loan balance size. However, the seasoning over 50 months will help on that. Now, if you go to our monthly company update, you'll see that that section of our portfolio, in terms of its size, was the fastest paying.

You might see that increase a little bit over time, but you get through the seasoning curve of 60 to 72 months which would be the next year to year and a half and then that would stabilize over time and actually, perhaps based on the normal way those curves work, would actually come down a little bit.

Regarding our 30-year fixed rate assets, I can't see that being picked up much at all, particularly because 88% of them have such a low loan balance and particularly where the rates are right now, they're just not going to refinance. So that's the majority of our assets.

But to your pointed question, over time, you do see an increase in prepayments and then they peak-out oftentimes between five and six years and stabilize or come down. Exposure to the expense for amortization right now, it continues to be fairly low.

We don't see it as a problem affecting earnings in the near term, unless we get a big rally here, Michael..

I guess just one other one. You guys chose to take the dividend slightly higher over the next couple of months. I mean, it would've been 32, you're taking it to 33, versus just the 8:1 reverse split.

Does that say anything about your expectations about earnings power going forward or how should we think about that in light of current market views on likely Fed tightening and the book value decline, all else equal, does put some -- again, all else equal, suggests the portfolio not growing.

So I guess the question is, is there anything we should read into that dividend, that change, slight change, as much as it is, regarding it?.

You can see that our Quarter 2 earnings were a little bit above what we paid out and that was the $0.04 a month. Right? And so we also stated this morning that we earned our $0.04 that we would pay it in July. We actually appear to be earning slightly more than that.

And as we look out, we thought the chances for the first Federal funds rate increase would be September, so we announced July, August, September. The only risk to that I could see at this point would be just some phenomenal change in the environment where we'd have to reduce leverage and couldn't pay it.

So unless there's a situation where rates went up really quick and we felt we needed to sell assets to reduce leverage, we're fairly comfortable and we've been indicating this in our monthly company updates as well of being able to earn, on a core income basis, the dividend we're paying for this third quarter..

Yes, so certainly the third quarter, that makes sense. Your earnings came in pretty much on top of where we expected. Again, with the monthly disclosures and the forward guidance, it's pretty transparent.

I guess maybe a different way to phrase a question is, a lot of mortgage REITs take a very forward looking approach and say, yes, maybe we're earning the equivalent of $0.33 after the split in the current quarter, Q3, but because of Fed tightening and so on and so forth, the way the swap book progresses, that's probably going to go down and so you'd see some preemptively trimming as opposed to taking up even slightly.

And so I guess the question is, when you guys think about that dividend and the Board sets that dividend, is it very much a pay what you earn and take next quarter as it comes or is there more of sort of an attempt to smooth over time sort of approach?.

There is definitely not an attempt to smooth. So there's two or three components here. Number one, we're one of only two, I believe, REITs that announce their dividends in advance, so our estimates and the work we do to determine 90 days in advance what we're earning is pretty profound. So we're actually going forward as well.

The market conditions have changed so much that it's very difficult to give you -- I can't even tell you right now for October what the dividend will be. We just don't have enough information yet.

Are we going to put on some of our forward starting swaps? Does the Fed go ahead and increase? I think it's generally well known that if the Fed jumped 25 basis points tomorrow, most of the agency REITs are going to have a 10% approximate decline in earnings just bingo, right away. And that's before they reinvests and it resets.

So there is that risk out there. That would take a company like ARMOUR from 11.5% ROE down to the mid- to high 10s. So those are the kind of dynamics that are going on.

We would like to always have a market return that is competitive enough so that people want to earn our stock and so that's one of the goals of the Board is, can we create a competitive return that makes it an attractive investment whilst maintaining as much book value stability as possible.

And as you know, in 2014, we underperformed in that regard, because we were well too conservative and so now, we have more of an even keel approach. And our key rate durations actually have that same kind of approach where it's a fairly well-distributed amount of key rate durations. I hope that's helpful..

Yes, absolutely. And if I may, just one more, a little more philosophically. Investors that have looked at the group, we've heard this from a number of people, folks that have held onto the stocks, look at the performance across this quarter. And I think, as you said, your book value was not out of line with peers.

In fact, it was a lower decline than the other fixed rate guys. But people still look at it and say, jeez, over the last two years, rates just haven't moved that much and yet book values just keep going down.

So I guess the philosophical question and the answer that I come up with and you could tell me if you agree, is that despite the Feds' best attempts to telegraph, there's been a ton of rate volatility and in the end, not a whole lot of rate move.

And what has proven or at least seems to me proven, to be the case, is that the rate volatility just beats you guys up, because to some degree, you don't have much choice.

When rates move from 1.5% to 3% and then come back to 1.7% and then go back to 2.5%, it's naive to think you can get through all that without making some changes to the portfolio and that, in isolation, ends up being worse than if the Fed had actually tightened.

So as we look forward to Fed tightening and the Fed actually finally doing something, I guess the broad question is, what's worse, more of this volatility or the Fed actually doing something and the market stabilizing, even if it's a flatter curve?.

I think we would take the Fed tightening and stabilizing and a growing consensus that the distribution of rate outcomes is more evenly distributed on both sides than the volatility. The story you just told was really the story of the last half of 2013. Not so much this quarter which is really a more straightforward spread story.

But you're absolutely right that the volatility is the toughest thing to deal with and that informs a lot of the ways that we hedge the book and the amount of hedging we've got on and the liquidity we carry.

What, for example we had to do in 2013, when we had close to a doubling of rates, but ultimately, didn't come to much, but had to reduce the portfolio to keep leverage under control and manageable.

So stability, even at the cost of a somewhat higher rate environment, would always be our preference over the sort of volatility that we've seen in the past..

Just to repeat the comments that Scott made early, our DV01 for rates is 1.2 million, I think, approximately. Our DV01 for spreads is at 8.2 million. And so the volatility increases spread widening or is a key component in spread widening and that's where a lot of your book value degradation has been over the last quarter.

As I listen to comments from our peers, I hear the same thing from them and, of course, the same thing from our lenders..

Yes, well let's hope for a more stable rate environment and it's probably a flatter curve, but I think that's better than a volatile curve. Anyway, thanks for the comments as always, guys..

[Operator Instructions]. And our next question comes from the line of Brock Vandervliet with Nomura Securities. Please proceed with your question..

Could you just go through kind of your cost of funds dynamics in the quarter, how much of that was driven by a great percentage of the forward starting swaps and how that kind of flowed in? Thanks..

And so, Brock, like we've said, repo rates crept a little bit. The majority change was the move from some current pays to forward starting swaps. I don't have in front of me the amount, but we moved, I believe, maybe 2.5 billion from current to forward and that definitely changes the cost of funds for the quarter.

But the reason we did that is because there's no sense to pay for protection currently if the Fed's not going to move yet and so that's the reason we did it..

Yes and as we did that analysis Brock, we said, what can happen in the next three months, six months? And let's suppose we get 25 basis points in September, well, that still doesn't get some of those swaps to kick in and start paying. It reduces, maybe, a little bit the negative carry cost of them, but it doesn't make them cash flow positive.

And so we said, okay, if we kick that out 3, 6, 9, 11, 12 months to where we think the risk really resides, it's sort of like buying insurance and paying for the insurance in the period when you think you're going to need it, because as we look at it, we came to the conclusion that even if the Fed did adjust 25 in September, it's cheaper at some level just to sort of eat that for a few months than to pay the swap cost for it..

And to be more explicit, for example, today, you could do a three year swap at 129, so you pay 129, I receive three months at 29, so you're paying 100. Well, if rates go up 25 basis points, you're not in a good place with that. So the forward starting swap provides the book value and you take a little bit of risk.

Now, if you do get a little bit of a bear seeker, you can sell lower-yielding assets to buy higher yielding assets which it obviously didn't happen in the 2006/2007 period, but periods prior to that is exactly what happened.

Now, as we've said before, we do expect a little bit of a flattener here and that's why we have more of an evenly distributed key rate duration. So, I hope that answers your question..

Okay.

And as a follow up, how should we think about the cost of funds, say in the next couple of quarters? It sounds like there's going to be a bit of a claw back as these forward starters gradually come on?.

It depends on where we're. As Jeff said before, it's a dynamic analysis. We're carrying a substantially bigger swap book than we would carry, in quotes, normal times.

So I think the question for cost of funds is what portion of current pay swap book are we going to feel is appropriate as we roll forward? As we were talking a few minutes ago, in an environment where things seem to stabilize suggests a much smaller swap book.

If you take a look at our monthly updates, we've always said we had a target of at least 40% of the book covered in swaps. We're double that to the plus.

And I guess our hope would be that normal times, at least as far as prospects for rates, do come back at some point and we will have a much smaller swap book and a much lower cost of hedging falling through the cost of funds..

And one of the great things about the monthly company update we put out is, you can check every single month to see what's developed with our swap book and then go ahead and put that into your estimates.

But I would think it would be very hard for any analyst who covers any firm in this business to have any idea of what Q4 or Q1 next year is going to be, because there's too many moving parts.

And this is what we spend our days analyzing and using all our key rates and our BlackRock solutions, that on a daily and weekly basis, do we need to add, do we need to subtract? And I'll tell you, we've been very quiet in that regard over the last quarter and it's proved to be the right thing to do.

It seems sometimes, the more you spend changing things, the more that can actually cost you over a long period of time..

Okay. And maybe asking it a different way. In terms of your set up, it sounds like you are expecting a flattening into the process of tightening.

Would that, all else equal benefit book value?.

A flattener right here probably doesn't change book value very much. Our exposure and our DV01 exposure on the short end of the curve is fairly equal to what it is on a 10-year. As I said, our key rate durations are fairly even. Depending on the nature of it and where it's coming from, it might mean the demand for mortgages is pretty good.

As people are stretching because of the flattening curve to derive yields for their portfolio, in that kind of situation, mortgages could get back a lot of the spread widening they had in the previous quarters. So actually, that's really the dynamic. Once again, Brock, 1.2 million in rate DV01, 8.2 million in spread DV01.

So that's where you're going to see the changes in book value derived, for the most part..

And there are no further questions at this time. Please continue with your presentation or closing remarks..

Well, we thank everybody for joining us today. As always, if you have questions, call the office. Scott, I, Marc or Jim will usually call you back the same day, unless we're traveling. And we appreciate your interest in ARMOUR and we're happy to see the stock up $0.08 or $0.09 this morning as well. Have a good day and thank you very much..

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines..