Cherry Hill Mortgage Investment Corporation (CHMI) Q3 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to the Cherry Hill Mortgage Third Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Michael Hutchby, Controller. Thank you. You may begin.

We would like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation’s third quarter 2015 conference call. In addition to this call, we have filed a press release that was distributed yesterday and posted to the Investor Relations section of our website at www.chmireit.com. On today’s call, management’s prepared remarks and answers to your questions may contain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ from those discussed today. Examples of forward-looking statements include those related to interest income, financial guidance, IRRs, future expected cash flows as well as prepayment and recapture rates, delinquencies and non-GAAP financial measures such as comprehensive income and core earnings. Forward-looking statements represent management’s current estimates and Cherry Hill assumes no obligation to update any forward-looking statements in the future. We encourage listeners to review the more detailed discussions related to these forward-looking statements contained in the company’s filings with the SEC and the definitions contained in the financial presentations available on the company’s website. Today’s conference call is hosted by Jay Lown, our President and Chief Investment Officer. Also present on the call today are Marty Levine, our Chief Financial Officer and Julian Evans, our Senior Portfolio Manager. And now, I will turn the call over to Jay.

Thanks Mike. Thanks everyone for joining us today on our earnings conference call for the third quarter of 2015. As part of today’s call, we have posted a presentation on our website a presentation that we will touch upon throughout the call and we will reference specific slides where appropriate. After our prepared remarks, we will open up the call for questions. REITs have endured significant ups and downs this year. Despite the continuous threat of forthcoming interest rate hikes, no Fed actions have occurred to-date. In fact, the U.S. 10-year treasury at quarter end was lower by 13 basis points versus December 31, 2014. Like many of our peers, we worked hard to position ourselves for a higher interest rate environment. In the meantime, the lack of clarity from the Fed on its monetary policy has certainly been a factor in the volatility of stock valuations. All eyes continued to be on when the Fed will become less accommodative in its monetary policy. In September, they seemed concerned about global economic conditions, in October, not so much. And based on their removal of that language, coupled with the strong employment data last week, we seem to be closer to some action this year. Coupled with the Fed holding off on a rate hike in September, the hedging environment in the third quarter was very challenging, with most spread sectors underperforming treasuries and swaps. Although mortgages held their ground for most of the quarter, at quarter end, mortgages significantly underperformed their hedges. As you have heard from many of our peers, this was a driving force in the reduction of book values for the sector this quarter. Since a portion of our portfolio was invested in agency RMBS, we experienced similar challenges. For the third quarter, our book value declined by approximately 3.7%, or $0.78. That said we believe our strategy in asset composition continues to highlight our ability to weather multiple economic and interest rate environments. Despite the volatile environment, we are pleased with the continued execution on our long-term MSR strategy. We recently completed all of the necessary licensing requirements and are now fully licensed to purchase MSR assets on a national level. In addition, as we disclosed last week, we acquired a $1.4 billion bulk MSR portfolio, our first MSR acquisition. Due to the expiration of the draw period in September, we borrowed the remaining amount available on our $25 million loan facility in September and then proceeded to use a significant portion of that amount to complete the MSR portfolio acquisition last month. Overall, our strategy remains very much intact. As evidenced by our acquisitions over the last few months, we have been working diligently towards becoming a more operational business. We have always said that we are building our business for the long-term and the blocking and tackling we accomplished over the past year has laid the groundwork for us to execute on our operational strategy. At the same time, we will continue to focus on investing in a prudent manner that emphasizes preservation of capital and quality of investments. We believe we are positioned well to take advantage of a rising rate environment and have the foundation in place to pursue additional opportunities to generate sustainable attractive risk-adjusted returns. Turning to our quarterly results, as shown on Slide 5, our third quarter core earnings declined slightly quarter-over-quarter. We generated core earnings of $0.47 per share and dividend eligible earnings of $0.49 per share. The difference between core earnings and dividend eligible income is largely due to the completion of our licensing efforts and the transitioning of the servicing of the Aurora portfolio to Freedom as subservicer. We anticipate that as we grow our servicing related assets portfolio, our core earnings will continue to be impacted by the acquisition expenses related to the purchase of these assets. The effects on dividend eligible income will be mitigated, because the MSR related expenses only affect Aurora, which is a taxable REIT subsidiary. To the extent, we are successful in our efforts to acquire additional MSRs we expect it will be a continued positive spread between the dividend eligible income and core earnings that will support our dividend. For the third quarter, we declared and subsequently distributed a $0.49 per share dividend to our shareholders. Slide 6 highlights our aggregate investment portfolio composition. At quarter end, our servicing-related investments, which include MSRs and excess MSRs represented approximately 41% of our equity capital and approximately 13% of our investment portfolio. The percentage change quarter-over-quarter and servicing related assets is attributable to drawing down the additional debt and temporarily investing in agency RMBS until the MSR acquisitions settled in October. Our RMBS portfolio at quarter end comprised approximately 51% of our equity and approximately 87% of our investment portfolio. As shown on Slide 7 through 9, our servicing related investments experienced a decline in value during the third quarter primarily due to the drop in interest rates. The current carrying value of the portfolio stood at approximately $85.6 million at quarter end. Our recapture agreement resulted in approximately $427 million of loans recaptured during the quarter, with Pool 1 posting a 25% recapture rate and Pool 2 positing a 58% recapture rate. Freedom continues to look for ways to protect and defend our portfolio in a competitive origination environment. Our Aurora portfolio performed in line with expectations in its first full quarter, with a CPR of 9%. An uptick in delinquencies that we saw shortly after the transfer of the direct servicing of the Aurora portfolio to Freedom in September has since reversed itself. I will now turn the presentation over to Julian who will provide detailed information on the investment portfolio and its performance over the quarter.

Thank you, Jay. As of September 30, the RMBS portfolio stood at approximately $580 million, excluding net TBAs, as shown on Slide 10, up from $433 million at the end of the second quarter. During the quarter, the RMBS portfolio’s growth was cheaply driven by the temporary deployment of the term debt proceeds pending settlement of the MSR acquisition in October. At the same time, we also deployed the servicing income on the MSRs, the amortization of the excess MSRs and the monthly P&I on the RMBS into new RMBS. The additional RMBS securities characteristics were similar to the RMBS in our existing portfolio. Post quarter end, the RMBS position was reduced to acquire the MSR portfolio in late October. At quarter end, our RMBS portfolio’s leverage stood at 6.5 times with the portfolio evenly split between 30-year fixed rate hold pools and a position comprised of 20-year and 15-year fixed rate hold pools as well as shorter duration assets. As shown on Slide 11, the RMBS portfolio’s collateral composition remained primarily comprised of loan balance collateral at quarter end. Compared to previous quarters, a majority of the new securities were positioned in story collateral with low pay-up premiums, 150K max, 175K max loan balance, and geo-collateral stories. We avoided purchases of expensive collateral stories pending the settlement of the MSR acquisition. For the quarter, the portfolio posted a weighted average three months CPR of approximately 7.8% and a weighted average six months CPR of approximately 8%. Our portfolio’s prepayments fees continue to outperform Fannie’s aggregate prepayment fees. The primary and secondary spread for mortgages widened during the quarter suggesting that originators were willing to increase production, but not at the expense of margins. For the quarter, we posted 1.31% net interest margin versus 1.46% net interest margin for the second quarter. The number is slightly misleading because of the temporary deployment of proceeds of the term debt in RMBS. Prior to investing the term debt proceeds, the average net interest margin for the first two months of the quarter was approximately 1.4% lower than the second quarter and driven by increased financing costs. During the quarter, the aggregate portfolio operated with leverage of 3.5 times and a negative duration gap. As shown on Slide 12 we ended the quarter with an aggregate portfolio duration gap of minus 1.32 years. The portfolio’s gap is driven by the composition of the RMBS portfolio associated hedges and the fact that 41% of the portfolio’s equity was composed of servicing related assets, including Excess MSRs and full MSRs during the third quarter of 2015. Before I turn the presentation over to Marty Levine, our CFO who will discuss in more detail the company’s financials, I will reiterate Jay’s theme as the third quarter can best be described is volatile and choppy for all rates and credit markets. Similar to other spread sectors, mortgage nominal spreads widened versus treasury and swap hedges. Throughout the quarter no spread sector was immune, a decline in the book value was because of our swap hedges outperforming RMBS into the rate rally. Since early October, we have seen a slight reversal, but markets are fluid and can change by next reporting. I will now turn the call over to Marty Levine for our third quarter financial discussion.

Thank you, Julian. For the quarter ended September 30, our net interest income was $4.9 million, the Excess MSRs, MSRs, RMBS and derivatives combined saw a net decrease in asset value of approximately $5.7 million for the quarter. Our GAAP net loss applicable to common stockholders for the third quarter was $5.1 million or $0.68 per share. Our core earnings as detailed on Slide 24 were $3.5 million or $0.47 per share. While our dividend eligible income was $0.49 per share. The GAAP between core dividend eligible-income was mainly caused by our licensing efforts which have now been completed as well as ongoing MSR portfolio acquisition expenses which may continue for the foreseeable future. As we continue to grow the MSR portfolio there may continue to be a gap between our core earnings and dividend eligible income. For the third quarter, our comprehensive loss which includes the mark to market of our held for sale RMBS was $2.1 million or $0.28 per share. As detailed in Slide 27, we used a variety of derivative instruments to mitigate the effects of increases in interest rates on a portion of our future repurchase borrowings. At the end of the third quarter, we held interest rate swaps, swaptions and TBAs with the combined notional amount of $438.8 million. For GAAP purposes, we have now elected to apply hedge accounting for our interest rate derivatives and as a result we record the change in estimated fair value as a component of the net gain or loss on interest rate derivatives. For the quarter, operating expenses were $1.3 million of which approximately $90,000 was related to our licensing efforts and other infrastructure costs relating to Aurora. For the quarter our total operating expense ratio as a percentage of average equity was 3.4%. On September10, 2015, we declared the dividend of $0.49 per share for the third quarter which was paid on October 27. Our goal remains to distribute regular quarterly dividends of all or substantially all of our taxable income to holders of our common stock and to the extent authorized by our Board of Directors. Now I would like to turn the call back to Jay for closing remarks.

Thanks Marty. Our shift towards a more operational business is in full swing with the acquisition of our first MSR portfolio along with the completion of all of our licensing requirements. Although the macro environment is challenging, we believe our long-term investment strategy remains very much on pace. We will now open up the call for questions. Operator?

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Michael Kaye with Citi. Please proceed.

A little bit more detail on that acquisition of $1.4 billion, what did the unlevered returns look like what were the levered returns look like any sort of estimate at this point?

Hey Mike, how are you doing?

Great.

Though it’s going to be hard for me to go into specifics about the returns, but what I can tell you about the portfolio is we thought it was a good first portfolio to start with, the counterparty was a bank which was appealing to us 95%ish retail because essentially about 2 years seasoning with very low delinquencies less than 0.5%, I think we have told you guys before that unlevered returns in the sector for Fannie Freddie type collateral were somewhere in the 8%ish range and I think today that still holds true.

Great. We just talked you said you were on call down the rest of the next bank loan and then you put it in agency RMBS, I mean was there any drag from doing that earnings this quarter?

I don’t believe that it was a drag on earnings, no. In fact I think it was a good investment while we work on completing the transaction.

Great. If I just look at your equity composition, I know that’s temporary a little bit lower MSR servicing related assets just temporary, but I think after IPO, you are close to 70% servicing, I mean how do you see like the migration going from agency to servicing where do you want to get that, what do you want eventually get that and do you think that cold cause any risk to the dividend as you shift?

So I think that that’s a number of questions in one, but one you are absolutely right when we started about 2 years ago it was approximately 70% and as rates dropped from 3% to 2% we were pretty careful about how we deployed capital from amortizations. At the same time the Excess MSR trade became less desirable based on things like the absolute level of returns and lack of sellers as well as leverage. And so what we did as you know is spend a lot of our time going through the appropriate motions to get license, so we are able to buy full MSRs. And so far we have now two portfolios, two pools of portfolios of MSRs that we have acquired that we believe are the first step at us becoming more servicing centric, again as we think rates now started to head higher. The ideal percentage of that portfolio I guess is fluid certainly more than it is today, but we are looking forward to analyzing and acquiring servicing related assets in the near-term.

And just I think you said you used most of the drawdown in the next bank already, I mean do you have any fire power to do more acquisitions from that next bank loan? And if you did want to – if you are basically – mostly deploy that capital, I mean, where is the shift going to come from? Are you going to be able to leverage more or is it just going to be basically shifting from RMBS back into servicing?

We do have a few million left of the next bank transaction with respect to deploying more capital outside of that. We continue to work on thinking about how to leverage the full MSR to be able to meet the return hurdles per our shareholders. And we are looking forward to being able to do something around that.

Okay, thank you.

Thank you. Our next question comes from the line of Steve DeLaney with JMP Securities. Please proceed.

Hey, good evening everyone. Thanks for taking the question. Sorry to be redundant, but I am getting the same topic that you just went through, but I would kind of like to ask it with respect to the 40 Act. So, rather than just – whether the equity allocation is 70% or 65%, looking at your purchase, I am just assuming that the outlay $1.4 billion, approximately 1% or so, I don’t think you disclosed the actual cost or the investment amount, but a lot of UPB for a relatively modest cost basis, I am trying to get at how much flexibility do you have with respect to your 40 Act exemption in terms of having to hold on to the agency hold pools? Obviously, I think everyone is enthused about the transition to more servicing assets and I am just trying to get a sense for how much more flexibility you have with respect to the 40 Act? Thank you, Jay.

Yes, so, no problem, Steve. So, I think the biggest thing to think about within the context of that is the servicing is now in a taxable REIT subsidiary. And so when we had just excess, we had essentially two assets and there was no TRS. And so we had the ability to go into the low to mid 70s in terms of percentage of equity and not trip those tests. With respect to the TRS because that has its own tests, I would tell you that it’s less than that. It’s somewhere the last time we checked in the 60s percentage that we would be in a safe, but that’s a fluid number just based on a lot of things around what else we invest in.

Okay, got it. So, I mean the structure, it sounds like it has given you some incremental flexibility?

Absolutely.

To reduce that allocation. Okay, great. Thanks.

Thank you. [Operator Instructions] Thank you. Our next question comes from the line of Paul Miller with FBR Capital. Please proceed.

Yes, hey, Jay. I have been traveling, so I don’t have the data in front of me, but are you saying that your recapture rate is in the 50% range right now?

I think the way we broke it out was Pool 1, which is a fixed rate pool and had a weighted average gross note rates still somewhere in the 3.5% range, had about 25% recapture rate. And then Pool 2 which is as you know, as the ARM portfolio does continue to have recapture in the high 50%. And I expect that Freedom will continue to work that portfolio hard, especially now with the threat of rising rates, but I would say that, go ahead.

Still on the 25%, you go ahead, I am sorry.

I would just say that if in an rising interest rate environment, we would expect that fixed rate portfolio would – the recapture rate would continue to drop, but those loans would be less than the money in danger of financing away.

And then correct me if I am wrong, but on the FHA product, right, either with higher rates, I mean with the change in policy, there is still a huge incentive for those to refi, am I correct?

So, it’s another good question. That Pool 1 was originally 50% FHA and 50% VA. So, the vast majority of what we own in terms of excess is VA in terms of loans, but within the context of the FHA MIP reduction, we saw a lot of the refinancing for that in the first two quarters of this year. I think what we saw in the third quarter was a very competitive origination environment as originators determined what market they are willing to work for within the context of continuing to try to go after that fixed population of loans.

And then we – I guess this is what, November, we have been through a month of TRID, I know you are not really originating, but have you have seen any of the CPR rates have any impact with TRID, or is it – you haven’t seen any of that impact flow through yet?

We should get that soon, but what I can tell you is which shouldn’t be a surprise based on any information that the industry has released is that origination volume has slowed as a result of the more cumbersome process around TRID. And I think that, that has been heavily discussed in most of the industry publications so far. It was an enormous undertaking. They had a year to do it, but there are a lot of parties involved in the process now around vendors and I think that’s probably a significant exposure from most originators.

And then for your recapture rates, is it treated a little bit differently, TRID, or is it easier to do TRID when you are refi and you have all the data – and then you don’t have the customer? I am just wondering, is it easier on your own servicing book under the new disclosure or is it still a pain in the butt?

No, I believe it’s the same difficulty of the process. There is less documentation. So, theoretically, you could say that refinances are easier to streamline in nature, but as a general statement, the amount of people or parties that touch the system now are more. Even though there are only two forms, the process is harder. And as you would expect as even though most people were fundamentally prepared, volumes are high. And I think it’s a general statement the industry is experiencing some overhang related to that.

Hey, guys. Thanks a lot.

Sure.

Thank you. We have no further questions in queue at this time. I would like to hand the floor back over to management for any closing remarks.

Thank you, everyone for joining us on the call today. We do look forward to updating you on our progress next quarter. Have a good evening.

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.