Cherry Hill Mortgage Investment Corporation (CHMI) Q3 2016 Earnings Report, Transcript and Summary

Greetings and welcome to Cherry Hill Mortgage third quarter 2016 earnings conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [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. Please go ahead.

We would like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's third quarter 2016 conference call. In addition to this call, we have filed a press release that was distributed earlier this afternoon 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 core and comprehensive income. 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, President of Cherry Hill. Also present on the call today are Julian Evans, our Chief Investment Officer; and Martin Levine, our Chief Financial Officer. And now, I'll turn the call over to Jay.

Thanks, Mike, and thank you everyone for joining us on today's call. We entered the third quarter focused on Brexit and a global rates market that was poised to keep rates low as global leaders digested the effects of the UK leaving the EU. During the quarter, the US ten-year treasury hit a historic low of 1.36%. Yet we closed the quarter at 1.59%, up 12 basis points from the previous quarter. Interestingly, the Praymak primary mortgage rate fell 11 basis points over the quarter to 3.47%. I think it's fair to say it was challenging for all REITs to manage through this volatility as the markets searched for firmer footing. Despite navigating choppy seas, Cherry Hill posted another strong quarter, generating core earnings of $0.54 per share and dividend eligible income of $0.57 per share. The past few quarters, we have benefited from series of transactions with Freedom that have contributed about $0.02 to $0.03 per quarter. Although we expect these transactions to end in the fourth quarter, we continue to believe our dividend is sustainable in the near-term. In addition, our book value per share rose 1.5% this quarter to $20.09. We're pleased that our investment strategy continues to bear fruit for our shareholders, and that the economy continues to demonstrate strength, we believe our balanced strategy will perform well over time across multiple interest rate cycles. Noteworthy accomplishments for the quarter include closing on a $25 million Fannie Mae MSR financing facility in September that will provide us with additional liquidity to pursue our MSR strategy. We've already drawn down on the facility, and believe it has the ability to grow with us over time. Overall, it was another successful quarter. And with that I will turn the call over to Julian, who will cover some more detailed highlights of our investment portfolio and its performance over the quarter.

Thank you, Jay. The beginning of the third quarter saw continued record low rates as the market continues to digest the implications of the Brexit vote. As the quarter progressed and investors began to believe that a Brexit impact would not be nearly as significant as once feared, interest rates started to balance from the lows, especially over the latter months of the quarter. The Fed's expected decision in September to hold rates steady had a muted impact on the market. As most investors continued to eye December for the next quarter rate hike, provided no market data or significant events spook the Fed. Despite the Brexit fears and fluctuating low interest rates, MBS spreads continue to tighten over the quarter. Driven by continued global demand for mortgages, the demand technical remains firm for the spread sector as the Fed and Asian investors continue to support the product. Refinancing and prepayment rates remain a concern despite a slight rise in rates over the past couple of months, and we expect prepayment risks to remain elevated as long as the lower for longer rate environment is present. Moving forward, slide 6 highlights our aggregate investment portfolio composition. At quarter-end, our servicing-related investments, which include MSRs and excess MSRs represented approximately 46% of our equity capital and approximately 14% of our investable assets excluding cash. Servicing related assets as a percentage of total assets declined slightly over the quarter due to amortization. Our RMBS portfolio accounted for approximately 48% of our equity and approximately 86% of our investable assets, excluding cash at quarter-end. As shown on slide 7 through nine, the current carrying value of our servicing related assets stood at approximately $93 million at quarter-end. With rates remaining at near trough levels for most of the quarter, our net CPR performed fairly well, with net CPRs for both MSRs and excess MSRs coming in at 15%. Approximately $1 billion of loans were recaptured during the quarter, with pool one posting a 65% recapture rate and pool two posting 58% recapture rate. Overall, the excess MSR portfolio produced $6 million in cash flow, including $3.2 million in interest income. Our full MSRs investments stood at approximately $28 million at quarter-end. As of September 30th, the RMBS portfolio stood at approximately $533 million, as shown on slide 10, a slight increase from $522 million as of June 30. At quarter-end, the portfolio composition remained basically consistent with the prior quarters composition with 30 year fixed-rate whole pools representing 61% of the portfolio and 20- and 15-year fixed-rate whole pools, as well as shorter duration assets, representing 39% of the RMBS portfolio. For the quarter, the RMBS portfolio posted a weighted average three-month CPR of approximately 8.8%, an increase from 7% in the previous quarter. As shown on slide 11, loan balance collateral remained a primary focus of the RMBS portfolio. As we've discussed previously, as long as the lower for longer interest rate environment prevails, we would expect prepayment fees to remain elevated. In addition, it's evidenced by the compression of the primary and secondary mortgage spread. Originators lowered margin to keep their origination pipelines full, which should keep prepayments fees elevated in the short-term. For the quarter, we stood at 1.32% RMBS NIM, net of our Freedom repo transactions, versus a 1.43% NIM for the second quarter. In the third quarter, repo costs averaged 78 basis points, versus averaging 74 basis points for the second quarter, but were offset by increased LIBOR, which affected the receiving portion of our swap hedges. We expect our NIM to continue to fluctuate in light of higher prepayments fees and repo costs. During the quarter, the aggregate portfolio operated with leverage of 3.2 times and a negative duration gap. As shown on slide 12, we ended the quarter with an aggregate portfolio duration gap of minus 2.89 years. The composition of the RMBS portfolio, associated hedges, and the fact that 46% of the Company's equity was invested in servicing related assets, including excess MSRs and the full MSRs during the third quarter of 2016 drove the portfolios duration gap. I will now turn the call over to Marty for our third quarter financial discussion.

Thank you, Julian. Our GAAP net income applicable to common stockholders for the third quarter was $5.4 million, or $0.72 per share. And our comprehensive income, attributable to common stockholders, which includes the mark-to-market of our held for sale RMBS was $5.8 million, or $0.77 per share. Our core earnings, as detailed on slide 24, was $4.1 million, or $0.54 per share, and we recorded dividend eligible income of $0.57 per share. While our core earnings have been elevated throughout this year, we expect our core earnings will revert to historic levels in 2017. As we noted on prior calls, we expect there will continue to be a slight difference between core earnings and dividend eligible income due to ongoing portfolio acquisition expenses. That said, we believe our current quarterly dividend levels will remain sustainable in the near-term. A 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 treasury futures with the combined no-sell [ph] amount of $446.4 million. For GAAP purposes, we have not 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 net gain or loss on interest rate derivatives. Operating expenses were $1.7 million for the quarter, of which is approximately $167,000 was related to our taxable REIT subsidiaries. For the quarter, our total operating expense ratio as a percentage of average equity was 4.4%. On September 8, 2016, we declared a dividend of $0.49 per share for the third quarter, which was paid on October 25, 2016. Our goal remains to distribute regular quarterly dividends and 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'd like to turn the call back to Jay for closing remarks.

Thanks, Marty. At this time, we will open up the call for questions. Operator?

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question today comes from Paul Miller of FBR. Please go ahead.

Hey guys, thank you. After last night elections, there's a possibility that we could have more of a stimulated fiscal policy, and the Fed might not or might raise rates in December, there some discussion they might wait to see in the transition. But I think some people you saw today, 10 years up, I think 20 basis points last time I looked. What are you guys -- are you guys in position to deal with a steeper year curve given the change in policies that could be coming down the road?

Yes, I mean, definitely, I think the way we set up the portfolio, we have, obviously, the swap hedges. I would say majority of the swap hedges this morning, we were looking at the portfolio and they definitely had a more of a flattener type of bent [ph] on the portfolio. Especially given that, I think at this morning more people were concerned with Hillary being elected, and with the possibility of [indiscernible] raising rates in December. That's on the swap hedges. In terms of the MSR and the excess MSRs, those overlay the overall portfolio, and they have more of a steepening bent to the portfolio. And if you look at a duration of our portfolio, at least at 9/30, we are minus 2.89 years, and the majority of the longer duration is driven by the MSR and the excess MSR as a steeper bent on the back end of the yield curve for the portfolio.

Paul, what also I'd like it's not like we haven't been here before. We were at 2.25 this year and we have been higher. We've been in a situation where the yield curve has been flatter and steeper, and given the composition of the portfolio, I think given where we are today, we think well-positioned fairly well.

And there's been a lot of new articles and some concern by the Ginnie Mae people that nobody wants to touch FHA servicing. And that seems to be right in your wheelhouse, you embrace of FHA servicing or GMA servicing rather than run from it. Have you seen a lot of good deals out there? Have you been able to participate and some of the discount pricing that people are talking about for this type of servicing?

So we don't have the Ginnie approval to buy MSRs yet. It's something we've been working on and we continue to work on, and we're in constant discussion with Ginnie and we feel like we are making progress. Freedom, I believe, has been actively involved, and you are right, I think that there is a view that the levels of these MSRs are trading at are definitely more fair than they were towards the beginning of the year. And I'm not going to comment -- I can -- I'm not going to comment for Freedom why they are specifically are very attracted to Ginnie MSRs. But our relationship with Freedom and with them as a sub service definitely gives us some comfort about being able to manage that oversight, and when we get the opportunity to purchase those assets.

Hey guys, thank you very much.

[Operator Instructions] There appears to be no further questions at this time. I would now like to turn the call back over to Jay Lown for closing remarks.

Thanks everyone, for joining us on the call today. Yesterday was an interesting day, and we were all having a good time absorbing it. We look forward to updating you on our progress on our fourth-quarter 2016 earnings call. Thanks.

This concludes tonight's conference. Thank you for your participation. You may now disconnect your lines at this time.