EXHIBIT 99.1
The Moderator: Good morning. My name is Rashanta, and I will be your
conference facilitator. At this time, I would like to welcome everyone to the
Friedman, Billings, Ramsey Group Third Quarter Earnings conference call. All
lines have been placed in use to prevent any background noise. After the
speakers' remarks, there will be a question-and-answer period. If you want to
ask a question at this time, simply press star and then a number one on your
telephone key pad. If you would like to withdraw your question, press start and
then the number two on your telephone key pad. Thank you.
Kurt Harrington, Chief Financial Officer, you may begin your conference.
Kurt Harrington, Chief Financial Officer: Good morning. This is Kurt
Harrington, Chief Financial Officer of Friedman, Billings, Ramsey Group, Inc.
Before we begin this morning's earnings call, we would like to remind everyone
that statements concerning future performance, developments, events, market
forecasts, revenues, expenses, earnings, run rates and any other guidance on
present or future periods constitute forward-looking statements. These
forward-looking statements 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, the effect of the demand for public offerings, activity in the
secondary securities markets, interest rates, our cost of borrowing, interest
spreads, mortgage prepayment speeds, the risks associated with merchant banking
investments, the realization of gains and losses on principal investments,
available technologies, competition for business and personnel, and general
economic, political, and market conditions. Additional information concerning
these factors that could cause results to differ materially is contained in FBR
Group's Annual Report on Form 10-K and in quarterly reports on Form 10-Q.
I would now like to turn over the call to FBR Group's Co-Chairman and
Co-Chief Executive Officers Emanuel Friedman and Eric Billings. Also joining us
this morning are Rick Hendrix, President and Chief Operating Officer, and Rock
Tonkel, President and Head of Investment Banking.
Emanuel "Manny" Friedman, Co-Chairman and Co-CEO: Thank you, and good
morning. Hopefully, you have all had an opportunity to review our earnings press
release issued last night. We are pleased with this quarter's results and would
like to add a few thoughts regarding what these results reflect in terms of our
current position as a firm.
As our record earnings per share and net income for the quarter indicate,
the third quarter was a very successful one for FBR. We have continued to expand
our existing businesses and have begun to enjoy success in several new areas.
During 2004, we experienced rapidly changing equity and fixed-income markets and
have been able to successfully execute our strategies in both our operating
businesses and our principal activities. We believe our results in the first
three quarters of this year have positioned FBR well for future growth and
profitability through both our existing core businesses and our new areas of
focus. Specifically, our investment banking businesses had its best quarter
ever, combining transactions for many new clients, with gratifying repeat
business. Assets under management in the mutual funds and alternative investment
vehicles have increased 43 percent since one year ago. Our mortgage-backed
strategy has performed well through a somewhat challenging interest rate
environment, preserving capital, and continuing to return high teens returns on
equity. Our merchant banking activities have continued to achieve returns
greater than that of the mortgage-backed portfolio, and we foresee many new
opportunities to deploy new capital in this business.
In addition to these accomplishments, this week we are scheduled to close a
$5 billion commercial paper conduit called "Arlington Funding" that will allow
us to officially fund warehouse lines of credit to various asset-backed issuers.
This conduit would enable to us compete more effectively in the asset-backed
securities business through access to the commercial paper market. This new
vehicle is an addition to Georgetown Funding which funds our own mortgage-backed
portfolios which we recently increased from $5 billion to 12 billion in
capacity. This new capacity would allow us to fund our entire mortgage-backed
portfolio through this conduit.
Now, I would like hand the call over to Eric Billings, who will discuss our
results in more detail, as well as our outlook for the future.
Eric Billings, Co-Chairman and Co-CEO: Thank you, Manny. I would like to go
through each of the different businesses and underscore a few points that we
feel are important which may not be easily discernible in our numbers.
As Manny previously stated, this was one of our best investment banking
quarters ever, and it featured some trends which we really think are worth
noting.
We continue to be ranked the number one underwriter of U.S. equities in
terms of after-market performance for the three quarters of 2004 as well as the
three- and five-year period ending September 30th, 2004.
Additionally, FBR is the number one ranked book running manager of U.S.
small capitalization companies (defined as those with a market capital of a
billion or under), common equity capital raises for the year to date through
9/30/04, and for the quarter, as well.
Of the 17 common equity transactions managed during the third quarter,
three were from our technology, media, and telecom group; six were financial
services; three were real estate-related; three were from the energy group; and
two were from the diversified industries group, demonstrating the growing
diversity of our business mix.
Significantly, we are also steadily building our roster of frequent capital
issuers who should become the base for the pipeline in future periods.
Specifically, we expect approximately half of our lead managed issuer clients
from the third quarter to initiate another capital transaction within the next
18 months. We should also note that we have raised approximately $4 billion in
24 lead managed transactions for repeat customers this year.
During the third quarter, FBR-led transactions totaling approximately $1.9
billion for issuers backed by six different financial sponsors such as private
equity or buyout firms. We believe that our recent focus on this important
client group represents a significant opportunity to expand our franchise in the
future.
Our efforts to establish an asset-backed security banking business have
begun to bear fruit. In total, during the quarter we have led or co-led over
$1.4 billion of ABS transactions.
Finally, we believe there is continuing trend toward capitalizing mortgage
assets through a combination of investment grade debt securities issued in the
MBS and ABS markets and public equity for the remaining portion of the capital
structure. The public equity markets represent an enormous source of capital
which we believe ultimately provides the most efficient capital for these
assets. When the proper leverage structure is applied, these assets can provide
naturally compounding and relatively stable earnings streams. We have seen this
trend in residential and commercial mortgages and believe it will continue for
some time in mortgage as well as other financial assets.
Over the last few years, we have established ourselves as a consistent top
10 underwriter of U.S. equities, often leading in the specific categories like
IPOs or small capitalization issues. One of our goals over the next few years is
to achieve a similar position in secondary commissions where we believe our
market share is substantially less. This will be harder to achieve because we
are not interested in competing for secondary volume based on commission levels,
but we do feel that we can improve our commission dollars significantly as we
broaden our research coverage and continue to strive to add value for our
accounts.
In 2003, FBR increased its market share of institutional commissions more
than any other firm, leading us to believe that we can continue to achieve
significant market share gains, using this disciplined approach in future
periods. During the most recent quarter, our efforts and results towards these
goals included: agency commissions 41 percent greater than in the third quarter
of 2003; September commission levels significantly exceeding July or August
levels.
Our asset management business is beginning to see significant asset inflows
which we believe is the result of our long-term track record in both mutual
funds and the alternative investment vehicles.
Net inflows into our hedge funds totaled $63 million for the quarter, which
was among our best quarters ever where a new vehicle has not been opened. Net
inflows into the mutual funds for the quarter exceeded $279 million.
As we mentioned in the press release, two of our funds were named "best
performers" for the third quarter in their respective categories by Barron's. We
are optimistic that our investment performance will continue to lead to growing
asset inflows in this business.
Turning to our principal activities, I will address our mortgage-backed
securities strategy first. The ROE in our MBS strategy for the quarter was
approximately 18 percent. Since the middle of June, the Federal Reserve has
increased short-term rates by 75 basis points, impacting our funding cost
including hedging during the quarter by about 23 basis points. Additionally,
medium-term interest rates have not risen, leading to a flattening of the yield
curve. Consequently, the increase in funding cost has not been completely offset
by higher yields as CPRs have not materially slowed, either.
Also during the quarter, we have decreased leverage and reallocated some
capital from prepayments to the merchant banking business, given the level of
attractive opportunities we see in that business. We feel the MBS strategy has
demonstrated over the last year that even in difficult markets we will preserve
capital and achieve strong ROEs. We continue to manage the MBS portfolio with a
neutral interest rate bias and reemphasize that we feel our strategy will
perform well in many different environments.
Our other long-term principal investing activities, including our merchant
banking and other long-term investment portfolios, returned outstanding results
again in the third quarter: Approximately 25 percent on equity. While realized
gains from this area were less than in the second quarter, it is important to
note that returns from this business will be volatile quarter to quarter, and
that we believe our merchant banking returns will continue their track record of
exceeding returns in the mortgage-backed security portfolio into the future. We
currently believe that the restructuring of the mortgage origination industry
from a one-time gain-on-sale model to a specialty finance lending model offers
some of the most compelling values we have ever seen and are hopeful of
capitalizing further on this industry transition.
During the first three quarters of this year, and particularly in this
third quarter, we have been pleased with our ability to both invest our growth
for the future while reporting growing record earnings in the current periods.
We continue to focus on using our investment principles and discipline to grow
our businesses and provide outstanding total returns to shareholders.
Thank you, and at this time we would like to open up the call for
questions.
The Moderator: At this time, I would like to remind everyone, in order to
ask a question, please press star then the number one on your telephone key pad.
We will pause for just a moment to compile the Q&A roster.
The first question comes from Todd Halky of Sandler O'Neill.
Todd Halky, Sandler O'Niell: Great quarter on the capital markets business.
Just a couple of quick questions. First on the investment banking pipeline, can
you just kind of give us an update on how that pipeline is looking there during
the fourth quarter? It looks like just you have already done about three deals
and another one coming this week, that hopefully it looks like the pipeline is
still pretty strong, but if you could just comment on this.
J. Rock Tonkel, President and Head of Investment Banking: This is Rock. We
have completed three book-run transactions in the neighborhood of $750 million
thus far for the quarter. The pipeline as it exists today has moved from in
excess of five billion which we stated at the end of the second quarter, to at
this point in excess of $10 billion due, in large part, to one large private
transaction.
Todd Halky, Sandler O'Niell: Great. Can the mix of that be based on new
client versus existing clients currently in the pipeline? Is it the same 25/75?
J. Rock Tonkel, President and Head of Investment Banking: Well, I think we
said for the year it was about $4 billion of total lead managed volume with
repeat clients against a total of about $9 billion book run, and I think that's
a fair mix going forward.
Todd Halky, Sandler O'Niell: Okay. And then on this spread in the
portfolio, we saw the decline in the overall portfolio. We saw the contraction
in the spread, and we saw the pullback in the actual leverage. Can you just talk
about going forward, and specifically in the fourth quarter as we look to the
current period, how you anticipate managing that business? Are you going to
lever it up a little bit, or kind of what is your expectations for the first
quarter--fourth quarter on that business?
Rick Hendrix, Co-President and Chief Operating Officer: This is Rick. We
don't intend to lever up into potential Fed tightening. The market obviously has
one, well, really more than a few tightenings priced in currently, and you are
seeing some of that in our current funding cost. We are going to continue to run
leverage between 9 and 11 times. And to the extent we experience additional
spread contraction, we are going to have variable ROEs in that business, which
is really the way we have always positioned that.
Todd Halky, Sandler O'Niell: Can you talk about the spread as you exited
the quarter, what level it was at? Was it significantly different from the
average?
Rick Hendrix, Co-President and Chief Operating Officer: It was moderately
less than the average for the quarter. As I said, the market has priced in,
continued tightening. So, as you get closer to those Fed dates, the cost to put
on short-term financing moves up in advance of that. But we have had 75 basis
points in increases so far. The hedges we have had on have protected the spread
effectively, and I think it's reasonable to expect, unless the market is wrong,
that we are going to have some continuing contraction in the fourth quarter.
Looking out beyond that is really difficult.
Eric Billings, Co-Chairman and Co-CEO: Also, again for knowledge, as we
look at these things and as we have always maintained, clearly one of our great
advantages, we believe, is our ability to allocate capital at the margin from
the spread-based business to, for instance, the merchant banking portfolio. And
as we stated over and over, the principle that we utilize there is to measure
all investments against that spread-based business because, by definition, we
have no credit risk there. We have to achieve higher returns in our judgment
over the next four--rolling four quarters. Clearly, as we see that spread coming
in a little bit, we tend to allocate more capital to that merchant banking
portfolio, which we believe certainly has historically achieved considerably
greater returns and give us the ability, we believe, to at least maintain levels
of historic returns and ROEs in that part of our business.
Specifically we think, for instance-- obviously, these things are
unknowable until we get there, but that many of the investments we are making
will be dividend-paying companies, and we believe the return on these dividends,
in fact, could potentially exceed the return on the spread-based portfolios in
and of themselves. And we also clearly believe we can achieve very substantial
capital appreciation in these investments. Now, time will tell, but we have this
flexibility. We continue to utilize that and we hope to be very thoughtful about
it.
Finally, we have mentioned in the past, remember we are constantly
exploring things like, for instance, are there ways for us to own, say, prime
mortgage assets where we would securitize fund them, and therefore substantially
eliminate interest rate risk and achieve essentially the same or, in fact,
higher ROEs. In addition, for instance, are there ways for us to be able to
portfolio nonprime mortgage assets? And while that does cause us to introduce
some credit risk, we would do it obviously on a balance basis, but again
eliminate interest rate risk in that part of the portfolio and achieve
considerably higher ROEs where we could actually, if we were to do that, do
things like buy private mortgage insurance and take even the credit risk down to
very, very low levels, in our judgment.
So, these are things that we continue to always be looking to do, and in
the totality of all of that, gives us great confidence and optimism in our
ability to continue to achieve in different environments very strong results in
the portfolio part of our business while we are growing our investment banking
and capital markets business, we think, very systematically. And obviously, as
you see vis-a-vis the growth in repeat business gives us somewhat of a geometric
effect--that's probably too strong of a word, but clearly a growing base from
which to continue to grow those businesses.
Todd Halky, Sandler O'Niell: And just to--thank you. And one final question
is, you have paid out, it looks like, $1.14 in dividends so far this year. We
calculate that, the REIT has earned roughly $1.16 to $1.20, depending on what
kind of expenses you are allocating to that segment of the business. That's what
I get a kind of feel for what the excess earnings in the REIT have been so far
to date in excess of that $1.14 that you paid out.
Eric Billings, Co-Chairman and Co-CEO: We have excess earnings in the REIT.
Your calculations are in the vicinity. We don't specifically disclose the
excess, but we do have excess. And as you know, it is our intent to pay out any
excess in the form of a special dividend, but we really do want to leave that
until we get there, and as you know, that is why we call it a "special dividend"
because we are not sure at this time what it would be. But our business
continues to earn in excess of the dividend in that part of the business, and so
at the end of this quarter we will pay whatever that is out in the form of
excess special dividends.
Todd Halky, Sandler O'Niell: Excellent. Well, thank you very much, and a
great quarter.
Eric Billings, Co-Chairman and Co-CEO: Thank you.
The Moderator: The next question comes from Mark Alpert of Centurion
Investments.
Mark Alpert, Centurion Investments: This is Mark Alpert. A couple of
questions. So, the amortization on the portfolio was $24 million, amortization
of the premium?
Rick Hendrix, Co-President and Chief Operating Officer: Correct.
Mark Alpert, Centurion Investments: What was it last quarter?
Rick Hendrix, Co-President and Chief Operating Officer: Last quarter, it
was almost $28 million.
Mark Alpert, Centurion Investments: But the payment rate, as you said, was
basically constant, right?
Rick Hendrix, Co-President and Chief Operating Officer: Right.
Mark Alpert, Centurion Investments: So, what caused the write-off this
quarter?
Rick Hendrix, Co-President and Chief Operating Officer: Well, the
amortization is based on what the premium is going into the quarter, again and
what our estimates of what future CPRs are. We didn't get big changes in CPRs
during the quarter, but the estimates used to calculate the amortization was
slightly different quarter to quarter.
In addition to that, we had, as you know, a lower balance at the end of the
quarter in September than we did at June, so we had a lower asset balance than
we were amortizing, as well.
Mark Alpert, Centurion Investments: Could you tell us what assumptions you
changed and what the change was?
Rick Hendrix, Co-President and Chief Operating Officer: The change was not
material. It was a point or two of CPR. It was based on what our estimates are
going forward.
Mark Alpert, Centurion Investments: All right. I mean--so, how can we tell,
you know, where you stand at this point, going into the fourth quarter?
Rick Hendrix, Co-President and Chief Operating Officer: Well, we have
unamortized premium at the end of the third quarter of about $193 million
against 10.9 billion of mortgage assets--and if you look at the portfolio and
where it's running today, assume that whatever assumptions you want to make,
high prepayments or low prepayments, you could take a percentage of that
unamortized premium and make an estimate of which prepayment premium
amortization would be in the fourth quarter.
Eric Billings, Co-Chairman and Co-CEO: But nothing overwhelmingly complex.
The CPRs continue to run in the high twenties, low thirties. Obviously, as many
people seem to believe, rates are going to continue to go up, and one would
logically assume at least over time CPRs would tend to slow, and you could make
those assumptions. If you believe the inverse, then you might expand them.
Everybody can make their own adjustments. But again, to be clear, these things
are at the margin.
Mark Alpert, Centurion Investments: And--I don't remember--what was the
unamortized premium last--three months ago?
Rick Hendrix, Co-President and Chief Operating Officer: 220 million.
Mark Alpert, Centurion Investments: On 12.9?
Rick Hendrix, Co-President and Chief Operating Officer: On 12.3 billion
assets.
Mark Alpert, Centurion Investments: Okay. And have you--I mean, have you--I
guess, maybe I had thought that because of portfolio was adjustable rate, the
volatility might not be as great as it seems to be. I mean, have you looked to
see how this would have compared if you held, let's say, a fixed-rate portfolio
that had some type of, you know, average coupon?
Rick Hendrix, Co-President and Chief Operating Officer: Well, certainly, if
we held the fixed-rate portfolio, we would have had, you know, a somewhat higher
spreads, although we would have had much higher premium amortization because of
the prepayment rates on those securities. We also would have had much greater
changes in book value, and in particular on the second quarter as rates backed
up. You know, this is a very low volatility strategy, in our opinion, and I
think that, the returns that it would generate would be demonstrating that.
Emanuel "Manny" Friedman, Co-Chairman and Co-CEO: There was no virtually no
volatility in the third quarter. Mark Alpert, Centurion Investments: No
volatility in what?
Emanuel "Manny" Friedman, Co-Chairman and Co-CEO: Of the amortization.
Mark Alpert, Centurion Investments: Okay. You mean relative to payment
rates? Is that what you're saying?
Rick Hendrix, Co-President and Chief Operating Officer: Right, and with
regard to the value of the portfolio itself.
Mark Alpert, Centurion Investments: Okay. The other kind of question I had,
given that you had such a strong quarter in deals, the brokerage--the trading
commissions weren't--fell. There used to be a correlation, you know, when firms
did a lot of underwritings. There was a lot of follow-up trades in the after
market. Is that correlation no longer true?
Eric Billings, Co-Chairman and Co-CEO: No, Mark. It is, to some degree,
true. It is not a direct linear correlation, but clearly that part of our
business, in fact, continues to grow, and when looked at properly on a quarter
to quarter, year to year type basis, you could see that growth quite, quite
strongly. And I think as we noted, we actually grew faster than any other
company in the United States in 2003, and that information isn't out yet, it
won't be until '04 is over, but we believe we continued to have evidence of that
kind of activity. Obviously, other things do affect it, though. July and August
tend to be very lethargic months, choppy difficult months, and volumes were
lower. So, you will see that for any given month or even quarterly basis.
Certainly, though, secondary trading tends to be more stable and
predictable. One of the things that we are very optimistic about, though, is our
market share in capital markets, investment banking specifically, is that is
bigger, quite a bit bigger than our market share and secondary trading. Now, you
know we don't do soft dollars. We don't trade without proper compensation for
the great research product that we provide to our clients, and we don't put huge
amounts of capital in essence buy business because it is not economic. So, we
are never going to have a direct correlation, but we clearly believe this, as
you continue to see the growth in capital investment banking activities, we will
see a strong correlation in growth in sales and trading, and we continue to
believe that it is very, very powerfully happening, and so we are very excited
about that part of business.
Mark Alpert, Centurion Investments: If I could ask one last question,
getting back to the portfolio, you said the hedges are continuing to work or are
working, and I guess I wasn't sure, but does that mean that you thought they
worked during the quarter, or that they are working now?
Rick Hendrix, Co-President and Chief Operating Officer: Well, I would say
both. We had an increase of 75 basis points in short rates starting at the end
of the second quarter, and our cost of funds changed between the second and
third quarter with 23 basis points.
Mark Alpert, Centurion Investments: Right, but also your portfolio yield
was also down, so that the total pressure was more like 40-odd basis points. It
was 40-odd basis points.
Rick Hendrix, Co-President and Chief Operating Officer: The other side of
that was on the assets yield, which was unrelated to the hedges.
Eric Billings, Co-Chairman and Co-CEO: Absolutely right, Mark, but as we
look at it, the portfolio is acting just as we would expect it to earn, where if
we earned north of an 18 percent cash return on invested equity which is very,
very acceptable to us, and all things being equal, nothing happened that
was--that we would described as unusual or disappointing at all, so I think in
that sense we believe the totality of the asset liability match is working
quite, quite well, from our perspective.
Mark Alpert, Centurion Investments: And they did in the third quarter, in
our opinion?
Emanuel "Manny" Friedman, Co-Chairman and Co-CEO: Yes.
Mark Alpert, Centurion Investments: And they continue to do in the
fourth quarter, but that doesn't mean we couldn't see some additional margin
pressure, obviously.
I guess I could ask it a different way. What would the margin have been if
you didn't have hedges in the third quarter?
Rick Hendrix, Co-President and Chief Operating Officer: It would have been
different, but obviously when we put swaps on, we are taking higher costs than
at the time that we put it in place, so it wouldn't have been full points
against the change in rate, but I think it's safe to say that it was somewhere
in the neighborhood of 20 basis points.
Mark Alpert, Centurion Investments: Thank you. I asked too many questions.
Eric Billings, Co-Chairman and Co-CEO: Thank you, Mark.
The Moderator: Your next question comes from Richard Herr of KBW.
Richard Herr, KBW: Hi, good morning, guys. I apologize if I missed this
earlier, but have you disclosed what the unrealized gains in the merchant bank
are currently?
Rick Hendrix, Co-President and Chief Operating Officer: We did not disclose
specifically what the unrealized gains are in the merchant bank, but I could
tell you that at the end of September we had unrealized gains of roughly 23 and
a half million dollars, and obviously, you know, we hold the number of 144A
securities in that portfolio that we keep at cost. If you add that to the 23.4,
it's more like $42 million.
Richard Herr, KBW: Terrific. And in terms of hedging, did you--obviously,
with the expansion of the Georgetown Funding, have you changed anything of how
you're thinking about hedging to your funding right now? Have you increased it?
I know last quarter we exited the quarter--around 50 percent of your hedging was
funding. Did you increase that, or has it been kind of the same?
Rick Hendrix, Co-President and Chief Operating Officer: We have not
increased it, and we have not changed our view on how we do that. And obviously
we kind of look at the opportunity and costs at all times as we look at hedging,
but we have made no changes in the third quarter.
Eric Billings, Co-Chairman and Co-CEO: But do remember, though, that at the
margin we have greater opportunities--as we see in the merchant banking, for
instance, and we allocate capital from the spread base to the merchant banking,
by definition that which is rolling off as the unhedged portion. So, on a
proportional basis, we tend to have a higher percentage of the portfolio that
ends up hedged just by that activity. And again, we do believe that that's
because it will give us higher returns, and has the effect of providing a form
of hedging, from our perspective.
Richard Herr, KBW: Okay. So, I guess you had a 50 million notional hedge
roll-off in July, and I guess with the prepayments and shrinking of the
portfolio, you didn't renew that, that swap?
Rick Hendrix, Co-President and Chief Operating Officer: That's correct. In
fact, that was a three-year old swap that applied to some specific securities
that we purchased back during the FBR Asset days. So, no matter what would have
happened, we wouldn't have renewed that.
Richard Herr, KBW: Okay. And the one that's coming up here, the 2 billion
and the 500 million in October, have you already rolled those over, those two
swaps?
Rick Hendrix, Co-President and Chief Operating Officer: We have not.
Richard Herr, KBW: Okay. So, you're hedging maybe less than 50 percent at
this point over last quarter?
Rick Hendrix, Co-President and Chief Operating Officer: Yes. As I said, we
haven't changed our view on how we hedged, but when you look at the dates of
expiration on some of these hedges, obviously some expired between the end of
the quarter, and we would not put new ones on to replace those.
Eric Billings, Co-Chairman and Co-CEO: But also remember this, guys: As we
said very consistently from the very beginning, we looked at the economic
results of potential activities. For instance, if the anticipation in the
capital markets is, for instance, that the one-year funding is going to be 245
today, if it went to 280, for instance, by way of example, the economics of
putting that hedge on doesn't make any sense whatever. The activity in the rate
world would have to be so bizarre and significant and instantaneous to have even
a neutral cash effect on running the portfolio. So, we do these things hopefully
with a thoughtful perspective on maximizing the economic returns we achieve in
the portfolio on a risk-adjusted basis.
And so, again it's always a function of looking at the economic returns
that we can achieve versus all alternatives. So, it's not purely mechanical. It
is hopefully very thoughtful so we can achieve the highest return on investment
equity on a risk-adjusted basis.
Richard Herr, KBW: Maybe you could help us out a little bit on that. I know
last quarter there was 191 basis points, and it was artificially depressed
because of pickup in prepayments, and at the time we were speaking a little bit
on the call about how the longer term run rate could be around 220 basis points,
and at the time it was kind of spoken of that maybe the 191 was sustainable in
the shorter term. We are kind of down to 151, and I don't think we think we have
seen the full impact of the three Fed rate hikes last quarter. I mean, what
could we see in the interest expense line item this quarter and into next year?
Could we see another 23 or 25 basis point increase in your funding cost, or is
it going to be mitigated somewhat?
Eric Billings, Co-Chairman and Co-CEO: Look, I think what's important
really at this point is you should make that judgment. Everybody should make
their own judgments on that based on what you believe rates will do. I think
what we are referring to, and I do think it's an important sort of idea to have
an understanding of our simple observation is that the nature of short-term
adjustable rate assets have a contractual ability and natural movement to adjust
the 225 basis points off the one-year treasury. Whenever rates stop going up,
then all of the assets will tend to that spread again, and it's a very natural
process that is always going on. So, if rates are going up for another three
quarters or four quarters, then that process will mitigate quite hopefully the
potential flattening of the spread. And then when they stop going up, then you
get a tendency for that spread to widen back out to that 200 to 225 basis
points, and that's sort of the natural process of short-term rate adjustable
portfolios.
We don't particularly make guesstimates on the process of that. We simply
observe that if you think about over a hundred percent of the time, in our
judgment, something in the low to mid 90 percent of the time, this portfolio
will achieve high teens to 20--low 20 percent, 24-5 percent cash returns on
equity. The other six, five to ten percent of the time, it will achieve returns
more to that or returns south of that. But the vast majority of the time it will
achieve these returns. We take no credit risk in the portfolio. These are
extraordinarily acceptable returns to us on a risk-adjusted basis at all times.
And really beyond that, it's impossible to predict and not particularly
meaningful to us.
Richard Herr, KBW: That's helpful. And just in terms of strategically
thinking about the REIT, obviously you spoke a little bit about de-emphasizing
the mortgage-backed securities portfolio and adding the merchant bank as there
are better returns there right now. Can we continue to expect to see that in Q4
and into '05, and what does that mean for your dividend?
Eric Billings, Co-Chairman and Co-CEO: Well, again, it's a marginal
consideration for us, where we see our current returns in our spread-based
business as measured against on a risk-adjusted basis the returns we believe on
a rolling fourth quarter basis we will achieve in our equity allocations, versus
for instance the merchant bank portfolio. We definitely believe today in the
environment we are in that our ability to achieve higher return than we will in
the spread based business exists, and that is because we believe the opportunity
to invest our capital in equities in the merchant side which provide significant
dividends, and we believe very substantial capital appreciation will give us the
ability to achieve very acceptable returns on a go-forward quarter basis. All of
that activity is in the REIT; therefore, we don't believe it would have any
negative effect on the REIT earnings/dividends. In fact, at the margin, if
anything, we obviously believe quite the contrary, but obviously time will tell.
Emanuel "Manny" Friedman, Co-Chairman and Co-CEO: As we mentioned earlier,
many our merchant banking investments have dividends that are equal to or higher
than the mortgage-backed portfolios.
Richard Herr, KBW: Thank you very much. Nice quarter in a difficult
environment.
Eric Billings, Co-Chairman and Co-CEO: Thanks very much.
The Moderator: The next question from Justin Hughes of Philadelphia
Financial.
Justin Hughes, Philadelphia Financial: Good morning. I just want to ask
about the book value. It was flat quarter to quarter, and so it looks like there
was a small markdown in the book. And given what rates did in the quarter, the
long was down a little bit, two year was about flat, I'm surprised you had the
negative mark. Am I looking at the right rates?
Rick Hendrix, Co-President and Chief Operating Officer: I have got a book
value going from $8.59 at the end of the second quarter to $9.26 at end of the
third quarter, so I have actually got an increase by $0.67. Part of that is a
reduction in the negative accumulated other comprehensive income, which is
appreciation essentially in a mortgage-backed portfolio and equities portfolio,
and part of that is retained earnings from a subsidiary.
Eric Billings, Co-Chairman and Co-CEO: What we would stress is that we
would look at the portfolio from an economic perspective, whereby because the
nature of these assets are government-backed short term in duration, the markup
and the markdown of these assets to us are immaterial, and we look at our book
value in absence of that. And our actual book value in absence of those marks
would be about $9.50 today, $9.52, and it has shown a very consistent growth, in
fact, by definition that we earn about $30 million, $32 million in the capital
markets platform, and that grows our book value on a quarterly basis in and of
itself. And the mark-to-market on these short-term adjustable rate assets, since
we hold the maturity and get our cash back a hundred percent or they adjust up
in coupon making them at least market-priced assets are not relevant, from our
perspective.
So, the real true core book value of our company is growing quite
systematically on a quarter-to-quarter basis, and that is what we can deploy in
capital to increase the returns on invested equity as we grow our business. And,
therefore, it is the important number to look at from an economic perspective,
and that continues to grow very steadily.
Justin Hughes, Philadelphia Financial: Okay. I'm looking at book value
$9.26 that says year end to date--I see, I was looking at year to date in third
quarter. That's why I thought it was flat.
Last question, you said there was the increase, the large increase in the
pipeline from one private transaction. Is that going to be 144A offering and
then later stepped up into an IPO?
J. Rock Tonkel, President and Head of Investment Banking: It's a private
transaction, we don't talk about individual deals. I said it's a large private
transaction, and that's really all I could say.
Justin Hughes, Philadelphia Financial: Thank you.
Eric Billings, Co-Chairman and Co-CEO: Thanks very much.
The Moderator: Next question comes from Joe Steven of Stifel, Nicholas. Joe
Stieven, Stifel, Nicholas: Hi, guys, first of all, good quarter. A number of my
questions, I think, have been answered or maybe beat to death, but two easy
ones. First of all,I was just trying to go through my calculations. Can you give
us your weighted average coupon on the MBS portfolio right now? That shouldn't
be too hard. That's number one. Number two, for modeling, can we get your termed
repricing of your borrowings on both the repos and the commercial paper?
Rick Hendrix, Co-President and Chief Operating Officer: Yeah, Joe,the
weighted average coupon at the end of September was 3.90, and the average dates
to roll on the funding, including the hedges, is about 45 days.
Justin Hughes, Philadelphia Financial: And I guess, Rick, with that, there
I mean, can you talk about--
Rick Hendrix, Co-President and Chief Operating Officer: No, Joe, it's 73
days.
Justin Hughes, Philadelphia Financial: Because I don't have my notes in
front of me, what was that as of the end of the last quarter? I could go back
and look.
Rick Hendrix, Co-President and Chief Operating Officer: 109 days.
Justin Hughes, Philadelphia Financial: It shortened up a little bit. That's
what I thought.
Any thought of linking that out at all, or what are your thoughts there?
Rick Hendrix, Co-President and Chief Operating Officer: Again, we haven't
changed our view on the timing of and the amount of the type of swaps that we
would put in place, but as Eric went through earlier--and I think you remember
this from following the portfolio for quite a while now--when we basically can't
make a case that we are going to be economically better off with the swap
because the market has priced in such aggressive increases over a short time
frame, we don't think it makes a lot of sense to go ahead and extend it at that
point in time. So, we make those judgments on a regular basis. When we had 5 and
a half billion million in swaps on, most of those were put on in a fairly tight
time frame, we thought it made a lot of sense to do so, and I think that the
performance of third quarter was borne out that those were good investment
decisions. When we find ourselves in an environment like that again, we will
extend the funding, but we not going to do it mechanically.
Justin Hughes, Philadelphia Financial: Thank you. Good quarter, guys.
The Moderator: The next question is from Mark Patterson of NWQ Investment
Management.
Mark Patterson, NWQ Investment Management: Hi, a couple of housecleaning
questions first. The average leverage on the MBS portfolio in the quarter versus
the 10.1 last quarter?
Rick Hendrix, Co-President and Chief Operating Officer: The average
leverage in the quarter was slightly higher. It was about 10.2.
Mark Patterson, NWQ Investment Management: Okay. And on the other
comprehensive income that was reduced down to negative 45 million, could you
provide a breakdown between the MBS and the taxable marketable securities in the
other categories like you had before?
Rick Hendrix, Co-President and Chief Operating Officer: Yes. At the end of
September, we had negative OCI within the MBS portfolio of about 77 million. We
had positive equities, as we mentioned earlier, of about 23. That excludes the
$19 million from the 144A that we carry in cost.
Mark Patterson, NWQ Investment Management: Okay.
Rick Hendrix, Co-President and Chief Operating Officer: And the balance are
small pieces related to a variety of other assets. The biggest piece of that is
the valuation of swaps at the end of September, which was about 6 million
positive. So, that gives you the negative 45.
Mark Patterson, NWQ Investment Management: Because I think Eric made a
comment about it just a couple of questions ago, but with regard to book value,
I think normally as the way you guys look at it economically as a business model
was to set negative 77 million on the MBS is not something that you consider,
and that would actually point the adjusted book value to $9.72 versus $9.49 last
quarter.
Rick Hendrix, Co-President and Chief Operating Officer: That's exactly
right.
Mark Patterson, NWQ Investment Management: Okay. I think I had something
else here.
The rule of thumb on your expenses on the qualified REIT, is that--I'm not
sure you have ever given that. Is that $5 million or three cents or something
like that for third quarter?
Rick Hendrix, Co-President and Chief Operating Officer: Well, you have got
a variable component in there, as well. When we look at it--
Mark Patterson, NWQ Investment Management: Is that kind of like on a $10
billion portfolio?
Rick Hendrix, Co-President and Chief Operating Officer: Again, I think the
easy way to look at it, Mark, is to assume roughly 10 percent expenses against
net income in that part of their pre-tax, pre-expense income in that part of the
business.
Mark Patterson, NWQ Investment Management: Great. It just seems like last
quarter you guys fielded a lot of questions about weaker results in the
investment bank on the broker line, and now the call has been loaded with some
questions about the MBS, but it seems to me that just shows that the model
should be commended--the model is working.
Emanuel "Manny" Friedman, Co-Chairman and Co-CEO: Great.
Mark Patterson, NWQ Investment Management: I appreciate that.
Eric Billings, Co-Chairman and Co-CEO: It's a great observation, Mark, and
we clearly do believe that's the case, and actually we hope that it's clear for
people to see and understand that.
The Moderator: The next question comes from Thomas Stephens of SAC.
Thomas Stephens, SAC: Good morning. I see that the model is working as
well, so congratulations. Just briefly, I just want to hear you talk a little
bit philosophically about the capital adequacy of the firm and your appetite to
buy back stock, and you guys have talked in the past about your philosophy in
terms of when it is and when it isn't the proper time to raise equity. In light
of the current environment, in principal investing in the opportunities that are
there, how does that change or how does that affect that decision-making
process? Thank you.
Eric Billings, Co-Chairman and Co-CEO: Thank you. We basically, first of
all, from a capital adequacy, we clearly believe that we have very, very strong
capital position as a company. And I know as many of you know, first of all, the
only leverage we deploy in the company is against to date government-backed
short-term adjustable rate assets where we take no true credit risk. We don't
leverage any other part of the company.
From a leverage perspective, about six and a half times leverage where all
that leverage is against government-backed short-term assets to be contrasted
with the average quote capital markets company in the United States is 25 times
leverage and has end-of-quarter leverage as high as 35 times. We do believe that
it appears extremely favorably.
As it relates to the question about buying back stock and/or accretively
raising capital, you know--I mean, the key for us is we look at these things
hopefully very, very thoughtfully and we look at everything so that the marginal
allocation of capital in the form of, for instance, buying back stock, we look
at that judgment to acquire stock in lieu of our opportunities to otherwise
invest that capital, for instance, in the merchant banking or spread base. We
look at that on an out three-year basis present valued back to the future
earnings stream we could get. If we believe the return is higher by buying our
stock, we would most certainly buy our stock back. As some of you may remember,
in FBR Asset, one of the predecessor companies before we merged the two
companies, there was a period of time when we actually shrunk the shares
outstanding in that company from 10.3 to three and a half million shares and
took the capital of the company at the time down from $210 to $85 million.
So, believe us, when we think these opportunities present themselves, we
would aggressively move if that were our highest risk adjusted return.
Simultaneously, when we look to raise capital, again, very important to
remember we are a deeply advantaged company, we believe, in the following sense:
The ability to raise capital isn't so difficult for companies. What's difficult
is deploying the capital on an accretive basis. Our great advantage, we believe,
is that in our areas of capital allocations particularly to spread based
mortgage-backed securities area and our merchant banking area have enormous size
of opportunity, and we have the ability to raise potentially capital, deploy
that capital on a very accretive basis, and add to the earning, add to the
dividends, add to the tangible book value the company, add to the intrinsic
value of the company, and we try to opportunistically do that when that's
available to us, and we deploy the same kind of analysis to make that judgment.
And so, knock on wood we will have opportunities to do these things hopefully to
continue to add value to the totality of the company.
Emanuel "Manny" Friedman, Co-Chairman and Co-CEO: We have $1.540 billion of
tangible capital which is a huge equity basis, and we are--the employees of FBR
are huge shareholders, so obviously we are extremely sensitive to the issues
Eric just went through.
The Moderator: Your next question comes from Steve Emerson of Emerson
Investment Group.
Steven Emerson, Emerson Investment Group: First of all, I would like to add
my congratulations to a job very well down, proving that this model works, even
in a less advantageous leveraged mortgage environment.
Can you give us some kind of color as to industry breakdown on the 5
billion to 10 billion pipeline of potential deals that you have?
J. Rock Tonkel, President and Head of Investment Banking: Sure. It's
about--just under 50 percent of the engagements in that pipeline are non--not
financial or real estate-related, and that crosses over the energy segment where
we have made great progress in building the franchise, particularly in the wake
of the Consol transaction which you may be familiar with, which is collectively
a billion-four private and along with the broader extension of the FBR franchise
has really begun to have a significant impact in the energy space, and the
technology and growth areas continue to grow in the number of engagements across
healthcare, software, hardware, services, et cetera, with a whole series of
advisory assignments across these industries.
The diversified industries area, which crosses over between
government-related entities, service companies and industrial companies, has
grown as well. So, each of these areas have--are seeing significant growth in
development of the franchise.
And I would add one more point, which is a very--we mentioned it in the
script, in our points, which was the expansion of the financial sponsor/private
equity franchise. That is an area that we really had not put any great amount of
focus into historically, and I suspect that in this year 2004 we will see more
than one hundred million dollars of revenue in the financial sponsors universe
and meaningful growth in that franchise going forward. Our ability to penetrate
that group as well as larger companies is really bearing out in the expansion of
our franchise due to the visibility of our company, the credibility of our
company from its combined performance overall, the league table rankings and the
consistency of our after-market performance. Those things all taken together are
creating what we think is a very rapid expansion in the banking franchise and
the overall firm's franchise, and that's bearing itself out directly in the
investment banking pipeline.
Eric Billings, Co-Chairman and Co-CEO: Steve, a number of transactions last
quarter, as you noticed, was roughly 50/50 financial and real estate, 50 percent
in all others, and that is the number of transactions. The capital rate split
was about 75/25, but clearly the growth in the other areas is greater than the
growth in, say, real estate certainly coming from a smaller base for sure, but I
think all of these trends bode very positively.
Steve Emerson, Emerson Investment Group: Excellent. Thank you.
Eric Billings, Co-Chairman and Co-CEO: Thanks, Steve.
The Moderator: Once again, if you would like to ask a question, please
press star and number one on your telephone key pad. The next question comes
from Richard Herr.
Richard Herr, KBW: I'm sorry, just one follow-up question. Just On the
pipeline, I guess the caller just prior to me said, is that true, 5 to 10
billion?
J. Rock Tonkel, President and Head of Investment Banking: The pipeline has
expanded from excess of five to excess of 10 due in large part to one large
private transaction.
Richard Herr, KBW: Oh, okay. Am I correct in saying you have about 1.9
billion publicly filed?
J. Rock Tonkel, President and Head of Investment Banking: Say that again.
Richard Herr, KBW: I said, am I correct in saying that your publicly filed
pipeline is about 1.9 billion?
J. Rock Tonkel, President and Head of Investment Banking: You know, I can't
say, Richard, I don't have that exact number in front of me, but I believe
that's about right.
Richard Herr, KBW: Thank you very much.
The Moderator: At this time, there are no further questions. Mr.
Harrington, are there any closing remarks?
Eric Billings, Co-Chairman and Co-CEO: No, but thank you all very much. And
go, Red Sox.
The Moderator: This concludes Friedman, Billings, Ramsey conference call.
You may disconnect.