Cherry Hill Mortgage Investment Corporation (CHMI) Q4 2018 Earnings Report, Transcript and Summary

Greetings and welcome to the Cherry Hill Mortgage Investment Corporation Fourth Quarter 2018 Earnings Call. [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'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's Fourth Quarter 2018 Conference Call. In addition to this call, we've filed a press release that was distributed earlier this afternoon and posted to the Investor Relations section of our web site at www.chmireit.com. On today's call, managements' 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 and CEO of Cherry Hill. Also present on the call today are Julian Evans, our Chief Investment Officer; and Marty Levine, our Chief Financial Officer. Now I'll turn the call over to Jay.

Thanks Mike, and welcome to today's call. As you may have heard from others in the industry, market conditions paired with portfolio composition, contributed to a wide range of results for mortgage REITs in the fourth quarter. The challenging environment was particularly difficult for those invested in MSRs and Agency RMBS. As REITs collapsed in response to a more patient Fed, Agency RMBS failed to keep pace with broader rates and did not provide adequate cover for MSRs. Despite market value declines we incurred in the fourth quarter, we believe that our approach and strategy with regards to our overall earnings power for the quarter and for 2018 paid-off. This discipline and consistency has carried over into the first quarter, as our asset selection of MSRs and RMBS continues to serve our shareholders well. For the fourth quarter of 2018, we generated core earnings per share of $0.66. Our core earnings results were primarily driven by very low prepayment speeds during the quarter in both the RMBS and MSR portfolios. We continue to outearn our quarterly dividend and due to our strong core earnings performance throughout the year, we were able to pay a special dividend to shareholders at the end of 2018 of $0.15 per share. As we look to 2019, we expect that the velocity of prepayments will elevate in the spring and summer as is the norm, particularly if rates remain low. As a result, we do not believe that $0.66 per share is a sustainable run rate. That said, we are still experiencing favorable prepayment speeds in the first months of the quarter, which continues to benefit our MSR and RMBS portfolios. Book value per share was off 9.7% in the fourth quarter, before giving effect to the special dividend. At December 31, book value per share stood at $17.58. As of January 31, we had recovered approximately 2% of our book value. The market moves we saw in the quarter were quite uncharacteristic of historical movements we've seen. Julian will elaborate more on this, in his remarks shortly, but we are working diligently to navigate the fluid rate environment over the coming quarters. We continue to believe that our MSR strategy is sound. And during the fourth quarter, we grew our portfolio by 10% through our flow program. At the end of the quarter, the MSR portfolio represented approximately 41% of our equity capital. During the quarter, we continue to utilize our ATM programs to issue preferred and common shares, resulting in net proceeds of approximately $10 million. Subsequent to the fourth quarter, we completed our second preferred equity offering in February, which raised approximately $48 million in net proceeds that we quickly deployed into both servicing-related assets and RMBS. While the fourth quarter was challenging, we were pleased with our overall 2018 performance, particularly with respect to our core earnings. Our management team was nimble and active throughout the year, using our investment experience to manage our portfolio. We remain mindful of market conditions and are focused on generating further strong results and preserving book value. Longer term, we believe we remain well-positioned to succeed across multiple interest rate environments and ultimately create additional shareholder value over time. With that, I'll turn the call over to Julian, who will cover more detailed highlights of our investment portfolio and its performance over the quarter.

Thank you, Jay. Our portfolio was affected by a combination of events during the quarter. Risk adverse sentiment permeated the capital markets, leading to both the decline in global equity indices and a widening of global fixed income credit spreads, as investors sought safe-haven assets. The widening limited the performance of our book value as investment assets could not keep pace with swap hedges. Swap hedges outperformed Agency RMBS as well as non-Agency mortgage securities. The rally in interest rates also had a negative impact on the market value of our servicing assets. In the fourth quarter the combination of RMBS and servicing assets underperformed versus previous quarters. For the fourth quarter, there were very subtle changes to the equity composition of our portfolio quarter-over-quarter. As shown on Slide 5, servicing related investments comprised solely of full MSRs represented approximately 41% of our equity capital and approximately 14% of our investable assets, excluding cash at quarter end. Servicing assets were slightly higher as a percentage of equity from the previous quarter, as a portion of RMBS proceeds were utilized to grow the servicing portfolio. Meanwhile, our RMBS portfolio accounted for approximately 55% of our equity, a few points lower than the previous quarter. As a percentage of investable assets, RMBS represented approximately 86%, excluding cash at quarter-end. As of December 31, we held MSRs with the UPB of approximately $25 billion and a market value of approximately $295 million. We grew our MSR portfolio by approximately 10% quarter-over-quarter and we expect to continue to grow the portfolio in 2019. Our MSR portfolio prepayment speeds declined based upon seasonality and the fact that the US housing market slowed during the period. Conventional MSR and government MSR, CPRs averaged approximately 5.2% and 10.3% respectively, down from 6.5% and 11.4% posted during the previous quarter. Both the MSR and the RMBS portfolio benefited from prepayment speeds, which were driven by the portfolio's composition and the seasonality for the quarter. As of December, the RMBS portfolio stood at approximately $1.8 billion, essentially flat from the previous quarter as some of the RMBS cash flows were redeployed in the servicing assets, shown on Slide 7. The RMBS portfolio’s composition was substantially similar to the previous quarter, the 30-year securities position stood at approximately 74% and the remaining assets represented 26%. However, the main softening in the market value was agency and credit spread widening. The market value of the non-Agency portion of the portfolio declined quarter-over-quarter as credit spreads widened and investors moved into safe-haven assets. In addition, the rise in the market value was limited as price premiums for specified pools did not rise to levels experienced in previous interest rate rallies. In the fourth quarter, the collateral composition of the RMBS portfolio continued to perform well, posting a weighted average three month CPR of approximately 5.1%, an improvement from the previous quarter and still outperforming Fannie Mae aggregate prepayment speeds. For the fourth quarter, we posted a 1.31% RMBS NIM versus a 1.18% NIM for the third quarter. The increase in NIM was driven by the portfolios composition and the improved amortization cost based upon better prepayment speeds, which offset rising financing costs. Near term, we continue to expect our NIM to fluctuate based upon rising REPO costs and the seasonality of the housing market, some of which will be offset by the received portion of our swap portfolio as three month LIBOR resets. During the quarter, the aggregate portfolio operated with leverage of approximately 4.8 times and a negative duration gap. We ended the quarter with an aggregate portfolio duration gap of minus 1.91 years. Going forward, we expect to continue to evaluate and alter the portfolio if necessary. I'll now turn the call over to Marty for a fourth quarter financial discussion.

Thank you, Julian. Our GAAP net loss applicable to common stockholders for the fourth quarter was $39.7 million or $2.42 per weighted average share outstanding during the quarter. While our comprehensive loss attributable to common stockholders, which includes the mark-to-market of our held for sale RMBS was $23.1 million or $1.41 per share. Our core earnings were $10.8 million or $0.66 per share. As Jay mentioned, our book value of December 31, was $17.58, a decrease of $2.04 per share from September 30th, or 9.7% before giving effect to the $0.15 special dividend. This consisted of an RMBS gain of 4.6%, a hedge derivative loss of 9.4%, and an MSR loss of 4.9%. As of January 31, we had recovered approximately 2% of our book value. We use 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 fourth quarter, we have interest rate swaps, swaptions, TBAs and Treasury futures, all of which had a combined notional amount of $1.6 billion. 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 the component of net gain or loss on interest rate derivatives. Operating expenses were $2.6 million for the quarter, of which approximately $493,000 was related to our taxable REIT subsidiary. On December 13, 2018, we declared a dividend of $0.49 per common share for the fourth quarter and a $0.15 per share special cash dividend on the common stock of the Company, both of which were paid on January 29, 2019. In addition, we declared a dividend of $0.5125 per share on our 8.2% Series A cumulative Redeemable Preferred Stock, which was paid on January 15, 2019. 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'd like to turn the call back to Jay.

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

[Operator Instructions] Our first question comes from the line of Steve DeLaney with JMP Securities. Please proceed with your question.

Gentlemen, the $0.66 versus consensus such as it is, it is a 30% beat. So really pretty dramatic, and you’ve identified it's slower speed on both MBS and MSRs, which is a nice combination to have. I was curious if there were any other items in there that you would deem to be one-time items or non-recurring? Or should we just take it as - take it as just the CPR impacts and obviously you know the seasonality related to that.

Yes. Steve, that's pretty much it. It was just the CPRs were incredibly low for the whole quarter. And I don't know if it's repeatable or sustainable, but that's the historical nature of it. Obviously, it's not what we expect in the market value, but it's over performed for the last quarter.

Yes. Well we did have that spike in rates I guess, September, October. So before the 10-year rally, you know, late in the year. So I guess, that when we were pushing up around 3% or so on the 10 year - and mortgages were 5% or 5.25%, I guess that carry over from 3Q application decline had - probably had something to do with that. Okay then that's good. Jay, I guess I'll throw this to you. MSR pricing, you know, it's hard to go to a Bloomberg screen and see where that's trading. I'm looking at the hybrid BVs for the fourth quarter, and the median was down about 8%. So, you've got a lot of company there, but two of the four companies that breached the 10% level, yourself and Two Harbors are in MSRs. So I guess my question there is just the magnitude - set the rest of the market aside. But the price indications in a risk off market like we had in a volatile market like we had late in the fourth quarter, did MSRs, were they punished to a larger degree than you would have thought? And have they recovered in 2019? And I'm curious how current pricing compares to maybe, say 3Q? Just help me get a little color there on how -- and if, you know MSRs, if your strategy works very well, I'm just curious if - that you think that the pricing on MSRs was a bit quirky.

So I'll take it in two parts. I definitely think that the valuations in the fourth quarter, as I think another company that you did not mention, discussed on their Q&A in their call, so the concept around escrows, and the valuation of escrows had a negative impact on the valuation aside from just the absolute market value. So while pricing held up through the quarter relative to deals, et cetera and around demand, we definitely saw weakness in the pricing around the valuation of escrows. And while that was not the main driver for value - for the valuation decline, it definitely had an impact on MSRs performing, at least in my opinion, worse than we may have expected. And that was a shift - as a result of the shift in the LIBOR curve, if you will...

Yes.

And you know…

The fed essentially confirmed in joint [indiscernible] agreement.

Yes. So, within the context of those - those valuations are driven off the forward curves. So with the value - with the forward curve shifting, as you probably heard from other guys, that had an impact on the portfolio that I personally probably did not fully expect. So with respect to the true pricing in MSRs, I think, Ray and the gang would tell you that given the technicals around the space, they still continue to perform well from a valuation perspective, while you had a fairly meaningful drop in rates for the quarter. So hopefully that helps on the valuation...

It helps a lot. Because it's a new color, I didn't pick that up. I wasn't on the PMT call or some of the others that were MSR focused. So that's helpful color to me to understand that piece of the valuation of an MSR for sure. And then I'll close out with this. You've used the term third-leg of the stool over the years, and I'm curious if sort of what you're thinking about credits specifically in QMs as that seems to be picking up, and as part of that, is there any activity production going on within freedom relative to expanded credit products? And I'll close it up with there, and thanks for taking the questions.

Sure. I think we're still focused on where in that space, we see value, year-to-date. I don't think that leg of the stool has taken on a very meaningful role in the overall composition in the company, but we do continue to look at it regularly, we do continue to have productive conversations with the Street around where we think we should play and where we can make a difference. And I do believe that's probably within the non-QM space somewhere, somehow, some way. But here today, I think we haven't really done anything around being in the sausage making business, if you will versus buying the finished product, and I think that's probably a big discussion for us here relative to how we fit-in. As it relates to freedom, I don't think Stan and the gang have made significant headway in the non-QM space. But - I know that they think about it.

Our next question comes from the line of Tim Hayes with B Riley FBR. Please proceed with your question.

I'm just going to piggyback off of Steve's question there. What is the internal view for rates right now? You mentioned in your prepared remarks that, and we've heard from the Fed, just getting more patient, the expectations for higher rates seem to be curbed. So just wondering how you guys look at the curve? And then, if you can maybe quantify the types of returns you expect across your asset classes, Agency versus non-Agency versus servicing?

So I'm going to give that to our esteemed colleague, Julian, to answer a little bit of context of making sure that he keeps it short.

Short-term, let's say over the next possible month or two months we're looking at, I think, current levels, we were at 260 plus or minus 10. I think from a longer-term perspective, we would expect that if the economy starts to improve in the second and the third quarter, rates could probably get into the 280 plus or minus 10 or 15 basis points around that particular area. I will turn it back over to you, Jay.

Okay. That was quicker than I thought.

That was pretty quick. Yeah, and then I don't know Jay or Julian, who wants to handle the second leg, but just kind of the returns you're seeing on the different strategies as it stands today?

Well, from the RMBS standpoint, I think you're seeing anywhere on a levered basis, probably between what's called 11 to 15 on that particular side of the business. And non-Agency, I think you're seeing brand new 2.0, probably somewhere between, let's call it 9 to about 13.

Yes, on the MSR side, units to the way we model this stuff. We're still seeing on a unleavened basis, depending on whether it's conventional or government, mid-to-high single digits.

And then, could you just clarify, were all MSRs are quieter in the quarter flow from RAM point?

In the fourth quarter, that's correct.

And so I know you've been pretty disinterested in bulk over the past several quarters, but as market volatility and our expectations for lower rates created many opportunities for you to add there?

You know, it's a good question. There is been a lot of capital raised this quarter to date. And those who you to suspect trying to put that to work and servicing have done so. So I think, that the technicals that we were dealing with in the fourth quarter have stuck around into the fourth quarter to date. I think that, this quarter is a little bit different and that there have been larger packages for sale versus smaller. So not much in the way of kind of $1 billion to $5 billion, but a lot more available in the $5 billion plus. So you can imagine who is working hard to bring those packages in. But we still see very competitive pricing in the space, despite the drop in rates. That may be a function of the view of where they think rates may be going. But definitely seeing a good amount of flow and competitive pricing.

[Operator Instructions] Our next question comes from the line of Henry Coffey with Wedbush. Please proceed with your question.

I think we're all sort of focused on in basically the same question. It seems that even with your rate forecast than a stronger economy, that the types of shifts in rates - we're likely to see your - fairly benign relative to what we saw last year. So assuming a stable rate environment around the sort of talk that you suggested, how does book value perform?

Well, so that's I think a function of a couple of things, and I'll let Julian talk more about it. But I think one of the things that we were surprised about was how mortgages performed relative to the hedges in the fourth quarter. And so to the extent the Fed continues down a path of normalization and balance sheet wind down. We have a very keen eye on how mortgages are performing relative to a lot of those things. And as I speak to - I'll let Julian talk more about the RMBS and the MSRs side. It's interesting that the primary mortgage rate has dropped quarter-over-quarter - from the fourth quarter to the first quarter. And so when you're looking at the valuation of servicing rights, you really have to pay more attention to the current Fannie Mae rate or Freddie Mac rate or the 30 year fixed rate bank rate. And if you do that, you'll notice that MSRs are down. And so I think that relative to what we talked about in our prepared remarks around what we saw through January, I think what you saw was a primary rate dropping, which caused servicing to probably continue to take a small hit or a hit, and then spread tightening on the RMBS side, which Julian would probably tell you was the main driver behind an increase in the valuation of the RMBS assets. Do you have anything to add to that Julian?

Yes, I mean, I think look, I think shape of the curve is very important. I think that once the Fed is kind of signaled that they are done, which I think and our belief it's probably between one more hike possibly two in the next year. If that's the case, you could see as much steeper curve - a much steeper yield curve would benefit all spread sector assets, not just RMBS but we would benefit the MSRs, especially at the back end, backed up and the front end may be rallied a little bit. So we would deem that to be a pretty significant, so the whole value of the portfolio could possibly increase. The Fed wind down of their portfolio is going to be have some importance here. The timing of it, did they continue to run RMBS off the portfolio? And how do they do it? Is it just amortization or is it selling of the particular product? There has been a significant amount of interest in all spread sector assets. There has been some interest in mortgages, obviously as REITs have come to market, as well as for money managers, domestic and international have been buying RMBS. The other big component, no one has really talked about a significant drop in volatility, whether it's been swaption wall in terms of gamma or vega, but also the [indiscernible] has come down pretty significantly. So the Fed can kind of continue on this path of patience and everybody kind of buys into it. And over a period of length of time, we see the second and third quarter kind of growth kind of improved, just not domestically, but globally. I think all spread sector assets can kind of do that. The easier said than done, to make a soft landing like they're attempting. But that's what they're shooting for, at least from a short term perspective.

Is there a world in which your core assets, your RMBS and your MSRs, sort of perform in tandem the way you'd expect? But because of the any sort of volatility factor in the market, your whatever hedges you have in place don't. And then that creates kind of a negative mark on book value? Or the opposite and I expect you would be positive mark on book value? But it's more the volatility that I'm looking at. And wondering did the fourth quarter was difficult for a lot of different companies involved in spread assets? So I'm wondering whether we see some sort of recovery in book value and more stability in book value, as a result of the fact that we're in an easier environment? Or is there causes for volatility out there?

Well, I think there is also - always causes for volatility, something hidden. I mean, obviously Brexit is taking a lot longer to settle that particular political dispute. China-US deal is taking longer to settle. Right now, the market seem to be very calm, based on those two events, with them expecting to get done in the second to third quarter. If those continue to lengthen in terms of the process, I would assume global growth doesn't pick up. I would assume there is a potential for growth going negative in Europe. There is a potential for US growth not to meet the 2.5% type of target and be somewhere below 2%. So in that particular scenario, I think you get a fourth quarter events again.

What I would say, Henry, though, is that we have definitely taken a look at how the portfolios are hedged holistically and individually. And we continue to try to make adjustments to make sure that - we can think about some of the ways to protect the portfolio. Should mortgages underperform again? And how the two asset classes interact together. I think last quarter was somewhat of an anomaly for us and most guys as for a pretty good company. But going into this year, I think, we definitely have spent a lot of time trying to think about how the two portfolios interact together, and how we can better protect book value.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Jay Lown for closing remarks.

Thank you. Thanks everybody for joining us on today's call. And we look forward to updating you soon on our first quarter results. Have a good afternoon.

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