Cherry Hill Mortgage Investment Corporation (CHMI) Q4 2016 Earnings Report, Transcript and Summary

Greetings and welcome to the Cherry Hill Mortgage Investment Corporation Fourth Quarter and Full year 2016 Earnings 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 Mr. Michael Hutchby. Thank you, sir. You may begin.

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation’s fourth 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 will turn the call over to Jay.

Thanks, Mike, and thanks everyone for joining us on today’s call. It’s quite possible that the markets hit a major inflection point in the fourth quarter on several levels. From a macro perspective, the election shocked the markets as investors began to expect potential deregulation and tax reform for 2017. And following the election, rates by considerably in anticipation of President Trump's proposals, as well as expected Fed tightening, which ultimately occurred in December. From a company standpoint, the quarter was probably the most transformative quarter we’ve had since going public more than three years ago. In mid-November, we announced the sale of our excess MSR portfolio back to Freedom Mortgage. Freedom had come to us with a compelling offer, and after careful consideration, which included evaluating the illiquidity of the asset, we took advantage of this unique opportunity and accepted the offer. The sale was highly constructive for the company. We immediately increased our book value, we gained additional flexibility in our portfolio and we generated significant proceeds to further pursue our full MSR strategy. And as part of the agreement, we are also receiving monthly yield maintenance payments of $250,000 from December 2016 through November 2017. At the same time, we eliminated the Company's exposures to the $60 plus billion Ginnie Mae MSR portfolio of Freedom. As the acknowledgement agreement among us, Freedom and Ginnie Mae was terminated in connection with the sale of excess MSRs. The transformation of Cherry Hill continued into the first quarter of this year. Last month we completed the final portion of the sale by exchanging the remaining excess MSRs we held for full MSRs and loans backing securities guaranteed by Ginnie. This was the conclusion of an 18-month process, working with Ginnie Mae to secure approval to service full MSRs, and we believe the sale of the excess MSRs to Freedom certainly helped pave the way. With the Ginnie Mae, our taxable REIT's subsidiary, Aurora is now authorized service loans for all three agencies. The acquisition of the MSRs roughly doubled the size of our portfolio and resulted in Aurora ranking in the top 70 or mortgage servicers in America. In all, the sale of the excess MSRs generated a gain on sale of approximately $15 million, $6.6 million of which was recognized in the fourth quarter, and after adjustments resulting in a $1.5 million realized gain on the sale of Pool 1 and Pool 2014. The remainder of the gain will be recognized in the first quarter as the exchange portion of the sale is completed in February. We further note that in accordance with GAAP, the total gain on sale includes 3 million of yield maintenance payments, effectively converting the payments originally intended to be part of the company’s earnings into a portion of Cherry Hill’s book value. Overall, for the fourth quarter we recorded core earnings of $0.51 while generating dividend eligible income of $0.56. Starting this quarter, we revised method for calculating amortization for the purpose of reporting core earnings in order to align ourselves with peers that also have substantial MSR investments. The amortization calculation refers to the portion of the change in fair value of MSRs that is primarily attributable to the realization of cash flows from the run-off of the portfolio, but that cash flow doesn’t come from all loans equally. Previously, we treated each underlying loan as if it had the same value, despite the fact that we just like our peers, actually assign different values to the purchased MSRs, based on the characteristics of those underlying loans. The foot note on Slide 23 shows what core earnings would have been for 2016, had this refined approach been used for the previous three quarters of 2016. Although this method of calculating amortization may alter the amount of amortization used to calculate core earnings in the future, we believe this is a more appropriate accounting method and is consistent with the accounting utilized by our peers that also own substantial MSR portfolios. If we look back the Company over the year, we see a pattern of steady dividends, protection of the Company’s book value and growth. We took our servicing portfolio from $2 billion to $3.3 billion, and secured MSR financing for the Fannie Mae MSR portfolio. The year began with the stock trading of $13 a share and ended with the stock trading at $18.19 a share, and the company paid $2.11 in dividends per share to investors over the year, which includes a special dividend announced in December. In the stand of the past four months, we’ve increased our portfolio's flexibility, raised our book value, received Ginnie Mae approval, doubled the size of our servicing portfolio, and have cash invested in liquid assets that can be deployed quickly into neutral MSRs. The strategy that existed at the time of the IPO has now transitioned into a more nimble operationally centric, that’s better positioned to succeed in a fluctuating interest rate environment. With that, I’ll turn the call over to Julian, who will cover some of the more detailed highlights of our investment portfolio and its performance over the quarter.

Thank you, Jay. As Jay noted, Trump's presidential election victory had a positive impact on markets, as investors and consumers showed renewed optimism with respect to U.S. economy and investments. Interest rates climbed immediately after the election, with the anticipation of potential inflationary fiscal policies from Washington. These potential policies, then the following rise in interest rates provided the Fed with the necessary cover to raise interest rates as I said December meeting. As December ended, the tenure closed the year at 225 basis points, up 85 basis points from September 30th close. We as well as other inventors are watching the Fed closely as they've expected the desire to raise rates three times in 2017, one of which is expected tomorrow. Moving forward, Slide 7 highlights our aggregate investment portfolio composition. At quarter-end, our servicing-related investments, which include MSRs and Pool 2 excess MSRs represented approximately 29% of our equity capital, and approximately 8% of our investable assets excluding cash. Servicing related assets as a percentage of total assets declined due to the completed sale of the Pool 1 and pool 2014 excess MSRs during the quarter, and the subsequent temporary deployment of the cash proceeds into the RMBS portfolio. As a result, our RMBS portfolio accounted for approximately 65% of our equity and approximately 91% of our investable assets, excluding cash at quarter-end. As shown on Slide 8 through 10, the current carrying value of our servicing related assets stood at approximately $61 million at quarter-end, as early Pool 2 remained from the excess MSR portfolio at the end of the year. With rates climbing in the latter part of the quarter, our net CPRs showed improvement with Pool 2 net CPR coming in at 14%. For the quarter, net CPR for our full MSRs averaged 15% with proceed of 12.5% net CPR in December. Approximately 478 million of loans were recaptured during the quarter on Pool 2, resulting in 71% recapture rate. At quarter end our full MSR investment stood at approximately $32 million. As of December 31st, the RMBS portfolio grew to approximately $666 million, as shown on Slide 11, an increase from $533 million as of September 30th, the increase was driven by the temporary deployment of proceeds from the sale of the excess MSR as mentioned above. During the quarter, the RMBS portfolio's composition changed as we increased our 30 years' securities position to 67% of the portfolio versus 61% at September 30th. 20-year and 15-year collateral, as well as shorter duration assets, represented 33% of the RMBS portfolio at quarter-end. In the fourth quarter, the RMBS portfolio posted a weighted average three-month CPR of approximately 7.7%, an improvement from 8.8% that was posted in the previous quarter, as shown on Slide 12. During the fourth quarter, we moved the portfolio into lower priced premiums securities as most markets were repositioning for higher interest rates. As interest rates sold off, the price premiums paid for specified pools weakened, and we would expect this story to continue in 2017 as interest rates march north. In the first quarter of 2017, priced premiums recovered as rates initially turned up and was lower, only to reverse, as the FOMC [ph] and investor sentiment shifted towards an improved inflationary economy, coupled by higher interest and mortgage rates. Loan balance collateral remained a primary focus of the portfolio. Due to the priced premium decline for specified pools, we were able to purchase collateral at attractive levels in the fourth quarter of 2016 and the first quarter of 2017 as excess MSR sale proceeds were put to work. For the fourth quarter, we've posted a 1.49% RMBS NIM, net of our Freedom repo transactions, versus a 1.32% NIM for the third quarter. The NIM improvement was driven by repositioning of the RMBS portfolio into 30-year collateral, specifically higher coupon mortgages and the portfolio maintaining consistent pre-phase. Similar to other REITs, we experienced higher repo cost in the fourth quarter. Repo cost averaged 93 basis points versus averaging 78 basis points in the third quarter. The increased cost were partially offset by increased three month LIBOR, which affected the receiving portion of our swap hedges. Going forward, we would expect our NIM to fluctuate based on higher repo cost. During the quarter, the aggregate portfolio operated with leverage of 3.96 times and a negative duration gap. As shown on Slide 13, we ended the quarter with an aggregate portfolio duration gap of minus 0.96 years. The lengthening of the duration gap from the previous quarter was driven by the sale of Pool 1 excess MSR and Pool 2014 and the subsequent redeployment of the cash proceeds into mortgages, coupled with high rising interest rates. I’ll now turn the call over to Marty for our fourth quarter financial discussion.

Thank you, Julian. Our GAAP net income, applicable to common stockholders for the fourth quarter was $26.2 million, or $3.48 per share; and our comprehensive income, attributable to common stockholders, which includes the mark-to-market of our held for sale RMBS was $8.1 million, or $1.08 per share. Our core earnings, as detailed on Slide 23, was $3.9 million, or $0.51 per share, and we recorded dividend eligible income of $0.56 per share. The total gain on sale of the excess MSRs to Freedom was approximately $15 million. During the fourth quarter, we recognized approximately $6.6 million of the gain, which after adjustment for previous unrealized losses on Pool 1 and Pool 2014 of approximately $2.6 million and an adjustment to interest income from the retrospective method of approximately $2.4 million, it resulted in a fourth quarter GAAP net realized gain of 1.5 million on the income statement. As required by GAAP, the $250,000 monthly yield maintenance payments to be received from December 2016 through November ’17 are included in the GAAP gain on sale total of $15 million, effectively converting those payments into book value rather than GAAP net income. For tax purposes, however, the yield maintenance payments are treated as taxable income as received, thereby increasing dividend eligible income. Because those payments are intended to partially mitigate the effects in the sale of the excess MSRs, we are including those payments in the calculation of core earnings. As we’ve consistently noted, 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 level will remain sustainable in the near future. As detailed in Slide 26, we used a variety of derivative instruments to mitigate the effects of increases in interest rates on a portion of our future repurchased borrowings. At the end of the fourth quarter, we held interest rate swaps, swaptions, TBAs and treasury futures and options on treasury futures with the combined no-show amount of $549.9 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 the net gain or loss on interest rate derivatives. Operating expenses were $1.6 million for the quarter, of which approximately $167,000 was related to our taxable REIT subsidiary. For the quarter, our total operating expense as a percentage of average equity was 4%. On December 8, 2016, we declared a dividend of $0.49 per share for the fourth quarter of the year, as well as a $0.15 special dividend, both of which were paid on January 31, 2017. 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.

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 comes from Steve DeLaney of JMP Securities. Please proceed with your question.

Thank you and congratulations guys on going your book value year-over-year and it sounds you have many mortgage REITs that have accomplished that this year or last year. So congrats. I have to admit, I got a little confused on the gain on the excess MSRs starting with the November 15 press release, and Marty your comments would helpful. So let me just ask to make -- I want to make sure I get this right. So originally the 16 million gain, it turned out to be 15 million, and now as I hear the comments on how we go from that figure to the GAAP recorded figure in the fourth quarter; did you intend in the November press release to basically describe what your gain was versus your cost basis in those excess MSRs, as opposed to what -- maybe the net accounting GAAP accounting gain might be? Can you help me maybe understand that original $16 million or $15 million figure? Thanks.

The gain we see off of the September 20, 2016, the last valuation that we have or that you have. So this was going to be the change basically in total from the excess MSRs. That was the last time you saw it, the basis there was we were getting $15 million more.

Go it, and the two items you mentioned against the 6.6, one I think of the 2.6 was just essentially a reversal of some unrealized gain that you had previously booked. Is that correct?

Unrealized losses which brought the basis down.

Okay, got it, unrealized losses had lower bases. I got it, I got that.

Yeah, so once you go back to December 31, a higher valuation than I did at September, 30.

Okay. Can you say at this point -- approximately can you give us an estimate for what the net accounting gain might be on Pool 2 that settled in February?

It’s a world onto itself.

I’ll withdraw the question. It’s an – it’s probably an unfair question. I -- just trying to get -- trying to make an adjustment to book value. That's all -- where I was going. Let me switch gears a little bit to what’s going to happen tomorrow with Fed likely to tighten, and who knows, if we get one or two more, whatever we get this year, but Julian, in your comments you mentioned fluctuation of -- potential fluctuation of the spread of the NIM. It looks like notional -- you’ve got a swapped RMBS ratio, that 62% notional. When you think about hedging book value, you’ve got a lot of negative duration in some of your MSRs. When you think about just cost of funds and hedging cost of funds in your spread, how do feel about your swap book and is it likely if the Fed becomes aggressive that we would see that swap ratio to RMBS increase going forward? Thanks.

Thanks, Steve. One of that -- obviously very important thing that we kind of think about is obviously our funding and the props surrounding that. We have kind of nimbled and kind of increased our -- kind of our hedge ratio to swap, throughout the year. I think there's a couple of things that we have to think about, not just the swaps, but we'll also have the swaption, and we also have the MSRs as kind of like our hedge to the RMBS portfolio, when they are fully operating. I would say yes, our repo cost has risen, and one of the things that has kind of offset that has clearly been the fact that three months LIBOR has risen over the last two years frankly and the Fed started to raise rates. In addition I would say throughout 2016, but mainly and probably the last couple of quarters, one of the things that we did in terms of our swap book is we took the opportunity. As rates went lower, we swapped out of higher interest rate swaps and moved them into lower interest rates. So for example, we would match book. If something was seven year, we’d lower the cost to a seven year, or we’d even extend it out to a 10-year. So if you look at the third quarter presentation versus the fourth quarter presentation, one of the things that you will notice is the actual fix rate on swaps went from 1.43 to 1.46, but the average life on our swap book went from let’s say 3.5 to basically 4.7.

Right.

So, we have been extending the maturities of our swaps. So the percentage of your hedge ratio is important, but also where you’re kind of laying in some of these swaps on the curve is also important to us. So look, we are expecting the Fed to go tomorrow. If we can get through some volatility that may be coming from Europe as well as additional Trump type of policies, I would expect them to go again to raise rates. That may be June. That could be September, but we are planning for that. In addition I would say that the shape of the yield curve will be important here. If they do raise rates, does the tenure actually rise and is it more of a kind of a bare flattener? We do have a good portion of our swaps around the five year -- five year and three year portion of the curve. So there is a lot of circumstances that could arise from simply the Fed just one, what they have to -- they raise rates; two, what the verbiage is that she delivers; and three, what the backlog looks like.

Right.

And Steve, this is Jay, The only thing I would add is that as we noted, we're looking to grow the MSR portfolio. So the portfolio is not -- it's going to be fluid. And so as we look to add more may negative duration assets, I think it would be very hard for Julian to pinpoint exactly where he feels comfortable or we feel comfortable around the hedge ratio, given the types of sourcing that we might add over the year as the Fed looks to do what it's going to do.

And just one quick one. When you thought of Raw [ph], they had I think that original 700 million of UPB. That was spanning a Freddie if I recall. I mean the discussion is obviously with Freedom. It's all been around Ginnie Mae. So I'm just curious, you guys actively as you look to deploy capital in the MSR space, are you looking at the GSEs as well as Ginnie Mae for full MSRs?

Absolutely.

Okay. Any thoughts about the relative merits of one versus the other? Is there any clear distinction or does it all come back to just sort of an IRR type of analysis?

Within the GSE's themselves or GSE versus Ginnie?

Just was there anything -- any, either risk or benefits one way or the other between say Ginnie versus the GSEs on -- as you are looking, it's beyond my level of my understanding of the nuances of MSRs, but I'm just curious whether there's something unique about Ginnie Mae's that may make those more attractive than Freddie - Fannie?

So I think it comes down to risk adjusted return, and Ginnie Mae on MSRs have an element of credit risk to them that I think you don’t see in the GSEs. And so when we look at that whether to deploy capital in either Fannie-Freddie versus Ginnie, we look at a few things including the absolute level of returns, the returns on levered basis, and the implied credit risk associated with the portfolios that we look at. And we're constantly looking at portfolios that might meet our return hurdles and our risk parameters. I can say that we think that the market is still full valued on the GSE front, on the Ginnie Mae space, probably not as much so, maybe a function of the market trying to assess the embedded credit risk in the loans, but what we are looking at all of those spaces to add to the portfolio today.

Appreciate all the comments. Thank you.

[Operator Instructions] If there are no further questions at this time, I would like to turn the call back over to Mr. Jay Lown for closing comments.

Thanks. Some of you guys are trying to get through this storm. So we appreciate you guys sticking with us. I know it's late. And again, we thank you for joining us on the call today, and we look forward to updating you soon on our first quarter results.

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