Cherry Hill Mortgage Investment Corporation (CHMI) Q3 2019 Earnings Report, Transcript and Summary

Good evening gentlemen and welcome to the Cherry Hill Third Quarter 2019 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].It is now my pleasure to introduce your host, Rory Rumore. Thank you. You may begin.

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's third quarter 2019 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, IRR, 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; Julian Evans, the Chief Investment Officer; and Michael Hutchby, the Chief Financial Officer.Now, I will turn the call over to Jay.

Thanks, Rory. And welcome to today's call. We remain diligent and proactive with respect to our hedging strategy and managing our portfolio in the third quarter, as we noted, we would do on our prior call. As a result, we're pleased to report an increase in book value and core earnings in line with our new quarterly dividend level. We achieved these results as ongoing macroeconomic and us China trade related concerns persistent.Global economic data remains softer and recessionary fears collectively weighed on the rate environment. The Fed telegraphed and ultimately executed on two 25 basis point rate eases based on those global concerns, and US 10 year yield declined too in the third quarter, well below the 2% level at the close of the prior quarter. As of September 30th, our book value increased to $17.01 from $16.80 at the prior quarter end, or a 1.3% gain net of the dividend.As we communicated on our second quarter call, we anticipated that the Board would adjust our common dividend. In September, the Board announced a quarterly common stock dividend of $0.40 per share, which we believe is a better representation of our expected near term earnings performance, given the increase in prepayments and lower yields environment for the reinvestment of capital.The Board also authorized a $10 million share repurchase program, given the significant relative valuation discount. We remain confident in our portfolio composition and investment strategy to deliver shareholder value over the long term and we expect to be active in repurchasing shares as appropriate. As we expected, prepayment speeds rose significantly in the third quarter, boosted by normal seasonality and the lowest mortgage interest rates since 2016.Our hedging strategy mitigated the impact both earnings and book value this quarter. Our proactive management helped us achieve core earnings for the third quarter of $0.41 per common share. Our MSR strategy remains a priority for us. During the quarter, we made MSR portfolio acquisitions exclusively from our float program as most bulk packages we evaluated consisted of higher note rates that did not fit our investment objectives.Our desire is to own an MSR portfolio that is balanced and diversified due to the significant growth of the portfolio last year, we are deliberately managing this growth to better position interest rate exposure. At the end of the third quarter the MSR portfolio comprised of approximately 36% of our equity capital, down from the prior quarter of 39%, largely due to the lower market value of the portfolio quarter over quarter.Looking ahead, we expect market volatility to persist as we enter in election year. We expect interest rates to remain contained, which will cause prepayments to remain elevated in the short term. That said, despite prepayment speeds still elevated through October, we believe stabilization will occur later in the fourth quarter, as seasonality and recent moves higher, and interest and mortgage rates eventually take hold.In sum we will continue to take a thoughtful and balanced approach in our portfolio construction. Our management team employs a proactive and collaborative effort in managing our portfolio, taking into account broader market actions and dynamic sector specific data.We believe we are positioned in hedge to protect shareholder equity. And we remain diligent about actively managing our investment portfolio to generate attractive risk adjusted returns for our shareholders. We believe there's meaningful value to be realized as we execute going forward.With that, I'll turn the call over to Julian who will cover more detailed highlight of our investment portfolio and its performance over the quarter.

Thank you, Jay. The geopolitical themes that were present in the second quarter carried over to the third quarter. Global interest rates rallied on manufacturing weakness, geopolitical concerns and continue rising US China trade tensions. These concerns increased volatility and lowered global interest rates. Despite increased volatility, a majority of credit sector spreads moved tighter and equity indices moved higher as the expectations of continued global Central bank intervention group.The Fed did not disappoint and delivered two expected eases, aiding most spread sector assets. Mortgages performance fluctuated during the quarter and ended this quarter softer as lower mortgage rates brought heightened prepayment and increased supply for years.As shown on slide 5, servicing related investments comprised of full MSRs represented approximately 36% of our equity capital and approximately 9% of our investable assets, excluding cash at quarter end. Servicing assets declined as a percentage of equity from the previous quarter as MSR valuations declined alongside with interest rates.Meanwhile, our RMBS portfolio accounted for approximately 62% of our equity, 5% higher than the previous quarter, due to a combination of additional purchases and rising market value during the quarter. As a percentage of investable assets RMBS represented approximately 91% excluding cash at quarter end.As of September 30, we held MSRs with UPB of approximately $28 billion and a market value of approximately $256 million. As we noted last quarter, given the falling interest rate environment, we made the prudent decision to slow the rate of additional MSR purchases, as the availability of near par collateral dwindled into the rally.In the third quarter, prepayment speeds remained elevated as interest rates and mortgage rates moved lower. Our conventional and government MSR, CPR has averaged approximately 24% and 17% respectively tor the third quarter. Conventional MSR speeds were up 12% in the prior quarter, while the government MSRs rose from 14%, CPR posted during the same timeframe.As of September 30, the RMBS portfolio stood at approximately $2.7 billion approximately 17% higher from the previous quarter and shown on slide 7. Quarter over quarter the RMBS portfolios composition shifted as capital was deployed. The 30 year securities position of the portfolio grew to 85%, up from 80% as of June 30 and the remaining assets represented 15%.In the third quarter, the collateral composition of the RMBS portfolio posted weighted average three months CPR of approximately 11% as a prepayment speeds accelerated further based on lower mortgage and interest rates subsequent to the third quarter. The recent rise and interest rates may have dampen the effect of future mortgage pre payments, especially in the latter part of the fourth quarter and into the new year, assuming interest in mortgage rates can maintain the recent high levels.For the third quarter, we posted a 0.87 RMBS NIM versus a 0.84 NIM for them for the second quarter. The NIM's modest increase was due to the repositioning of our RMBS portfolio and resetting some of our payer swaps to lower rates, which was partially offset by the increased RMBS amortization. We continue to expect the NIM to fluctuate near term.As we move forward, we would expect the NIM to maintain or improve due to improvements in asset financing levels, a better entry point for asset yields and slower prepayments. The transition may take several months, but we may be on the cusp. At quarter end the aggregate portfolio operated with leverage of approximately 5.9 times in a positive duration gap.We ended the quarter with an aggregate portfolio duration gap of a positive 0.24 years. As we move forward, we will continue evaluating also the portfolio as necessary.I'll now turn the call over to Mike for the third quarter financial discussion.

Thank you, Julian. Our GAAP net loss applicable to common stockholders for the third quarter was $5.4 million or $0.32 per weighted average share outstanding during the quarter. While comprehensive income attributable to common stockholders, which includes the mark to market of our held for sale RMBS was $9.9 million or $0.59 per share. Our core earnings were $7 million, or $0.41 per share.As Jay mentioned, our book value as of September 30, was $17.01, an increase of $0.21 per share from June 30, or 1.3% net of the third quarter dividend. 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 third quarter, we held interest rate swaps, swaptions, TVAs and treasury futures, all of which had a combined notional amount of $3.1 billion.For GAAP purposes, we've 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 the net gain or loss on interest rate derivatives. Operating expenses were $3.2 million for the quarter, of which approximately $598,000 was related to our taxable REIT subsidiary.I want to briefly mention an adjustment we made to our core EPS accounting methodology this quarter. As our portfolio composition has evolved over the past few years, we believed it was necessary to refine the MSR amortization calculation we use in determining the amount of realized and unrealized gains or losses on our MSR investments.Beginning with this past quarter, we've adjusted the MSR amortization method used for the calculation of core earnings to better reflect how carry on our MSR investments will vary with changing prepayment conditions. We believe this refinement, more precisely reflects the earnings power and returns expected of our MSR portfolio.On September 4, 2019, we declared a dividend to $0.40 per common share for the third quarter of 2019, which was paid on October 29, 2019. On September 13, we declared a dividend to 51.25 cents per share on our 8.2% Series A cumulative redeemable preferred stock and a dividend of 51.5625 cents on our 8.25% Series B fixed to floating rate cumulative redeemable preferred stock, both of which were paid on October 15, 2019.At this time, we will open up the call for questions. Operator?

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

Hey, thanks for taking the question guys. Look, I know third quarter was challenging for everyone in the CMBS and MSR world. But congratulations on the book value being a positive figure. And it's nice to see the stock come back here in the last month or so.Obviously a different rate environment on a couple fronts, the 10 year course. But also we've seen three month LIBOR come down pretty sharply here now, even just since September. And I'm curious based on what you're seeing in the repo market. Is that -- would it become a negative spread between what you're paying on your one month repo versus what you're receiving on three month LIBOR? I wonder if you could just comment on how that may have improved here in the last month or so. Thanks.

Hey, Steve, it's Julian. How are you? I would say in general, you're right LIBOR has obviously come down, repo has come down pretty significantly, I would say post quarter end. Even after what we've reported here, the third quarter, I believe in terms of our repo rate, we're posting like a 236. I would say we're currently seeing something about, let's say, 190 for three months repo. So we do see some improvements that will help improve the NIM.In terms of the negative part in terms of three months repo coming down for our swap positioning, we've continued to adjust some of our old payer swaps into new payer swaps to keep that receive versus what we're paying out on the positive side.

Got it. Got it. Okay, that's helpful. And just thinking about the 10 year, the decline and where your prepay outlook today versus maybe your prepay outlook in August or September. Whenever the lows were I think they were after Labor Day almost 50 basis points minus 40 some basis points from sub 150 to 190 something. How does that alone setting the repo aside?And that 40 or 50 basis points, you made, I think, a wise decision to take the dividend down meaningfully. But as you sit here today with close to a 2%, 10 year, can you comment on what that means to your earnings potential relative to being at 150, which is where the world was?

Yeah. I can try to tackle that, Steve.

Thanks, Jay.

So, one thing to note was that mortgage rates were pretty sticky on the way down relative to the 10 year. So I think they pretty much underperformed on the way down and outperformed to some extend on the way back up. And to that effect, I don't think you're going to see as huge a pickup in terms of speeds dropping meaningfully over the short term relative to what you may have seen in late summer, early fall.But we're hopeful that going into the winter months with previous fees naturally coming down, as well as the absolute uptick in rates that will get a breather from space. And I think we try to convey that in a speech saying at least through October, we saw that speech remained elevated. But we are hopeful that as we get to the latter part of the fourth quarter that we get a breather.

Yeah. Okay, so maybe it's really more of the combination of winner and rates and more of a first quarter thing and so much a fourth quarter thing in terms of magnitude of any improvement. In the…

Late fourth or early first, yeah.

Yeah. Okay. Thank you. And just one quick thing. The disclosure you made with respect to Freedom and the sub servicing agreement has all that servicing since been transferred to one of your other partners at this point?

Which statement you're referring to?

Well, this was in your proxy. In your proxy, you had made a statement and it said that they had not given notice of termination of the sub servicing agreement, and that the transfer of the servicing, you would be transferring sub servicing from Freedom to other servicers. And it said it would likely be completed in 2Q '19 or 3Q '19.

Right, so we are not -- that is -- I believe we corrected that. We're not -- given the RoundPoint acquisition by Freedom or post the acquisition of RoundPoint by Freedom we made a decision to, to keep that as is. And today they currently only service or sub service or [indiscernible] portfolio.But with the expected close of RoundPoint, and I have no idea when that's going to close obviously Freedom will become a sub servicer of a decent part of our branding portfolio. So, today I believe the official words that we said and more recently was that it was reinstated [indiscernible] and one of the documents off to get you there the actual number.

Yes. Okay. So the point is, you're going to -- the way things have worked out regardless of how we got there, it sounds like you are maintaining a relationship with Freedom to service a part of your portfolio.

That's correct.

Okay, that makes sense. Okay. Well, thank you. Thank all of you for your comments. And good job. Thanks.

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

Hey, good evening, guys. Thanks for taking my questions. My first one, just your weighted average interest expense went down this quarter. And it sounds like you expect that to continue trending down in terms of your funding costs there. But it doesn't seem like you're materially impacted by the disruption in the repo markets this quarter, at least on price level?But if not on price, were you impacted in terms of the availability of capital or haircuts or in any other way? And have you seen that normalized more broadly?

I'll take I'll take that Tim. We have seen it normalize, definitely, as the Fed has added an additional liquidity into these markets. And we expect them to continue to add as much liquidity as they've added currently or even a greater amount into the December timeframe as we move over year end.I would say we were not as impacted as maybe some of our other counterparties, because a lot of a repo that was impacted was overnight repo, majority of the repo we have has been more term, specifically, it's been three months on average. And so we were not as impacted as our counterparties.

Right, that makes sense. Thanks for that clarification there. And then, Julian, what are levered returns on MSRs and your prepay protected RMBS right now? Are you able to deploy capital accretively? And then how attractive do you view buybacks as a source of capital deployment right now with your stock trading at about 11% yield?

So I'll take the first one. And just repeat the second one, but I think given where we've been buying MSRs high single digits unlevered, let's call it 8 to 10. And I think our average advanced rate is in the 60% 65% range. So we're looking at low to mid-teens returns.

In terms of the agency RMBS. So I would say that that's a low double digits currently, given the backup that we've seen in rates, the asset yields are completely more attractive now than they were, let's say, a month ago.

And to the stock, I think what we try to convey on the call was that we expect to be active in repurchasing shares when it's appropriate, I think that's a fluid discussion. But we are committed to executing on that program. And what I don't have for you is a number of what we'll do, how we'll do it et cetera.

Okay, still helpful. Appreciate the comments there. And then you made -- well, you covered your dividend this quarter with quarter earnings. And you guys made some constructive comments around your NIM outlook. And I know that there's a lot of uncertainty and volatility potentially ahead. But how do you think about dividend coverage? Can you just remind us if core EPS is really the benchmark you guys use for setting the dividend or if you take economic return into account as well?

So I think -- it's a good question relative to some other calls over the quarter. But I still think that it's our desire to have a dividend policy that is representative of the earnings power here. And today I believe that still equates to core. And so we set the dividend at $0.40. We still think in the near term that we have the ability to cover the dividend if we get a break in rates and continue to rise and outlooks looks better for spread sector assets, great.But today what I think we tried to do is set a dividend level that we could sustain for a while. If you recall, I think our last dividend level was for 16 consecutive quarters or something like that. So we're looking to have a stable dividend if for some reason the market goes our way, great.

Okay. And I'll just sneak one more in here. If you would, just a book value update so far into quarter.

Yes. So I think at the end of October, it's somewhere around down around 1%.

Okay. Great. Well, thanks again for taking my questions and congrats on a strong quarter.

Thanks.

Thank you. Our next question comes from the line of Henry Coffey with Wedbush Securities. Please proceed with your question.

Yes. Good evening, and thank you for taking my questions. That 1% gain in book value is probably the hardest work you've ever done to get 1%. But I think it's a significant benchmark for all of us. So congrats there. We had a lot of discussions sort of online and offline, and I'm sure you thought a lot of about where you want to go as the mortgage market keeps shifting and evolving.The very tight focus on essentially agency assets is good. Have you sort of evolved in your thinking in terms of what you might want to do or is it let's be narrow and deep in one area and optimize value where we can?

For the 80-20 rule, I think the strategy still applies. We're consistently looking for opportunities in less than just rate sensitive areas to diversify. But today, we don't have anything to report around that. But 80-20 would still be that we're very focused on the two strategies that we can complement each other well.

Is there a place in this equation for something like credit risk transfer bonds or is that taking you too far away from your basic box right now?

No, we actually have owned a credit risk transfer bonds for a few years.

Okay, so that's an area where you would be able and happy to invest as opportunities present themselves. Any other sort of asset classes like that, that aren't MSRs aren't RMBS?

Yeah. Today, we're currently invested in some jumbo prime deals, as well as credit risk transfer deals in both cases.

Have those other assets the 20, as opposed to the 80, how have they performed for you and how the spreads are operating in those other assets for you?

Well, I would say that the spreads have tightened in Resi 2.0, the credit spreads. And they've also tightened in the CRT. I would probably argue that they are less attractive today then maybe they were, call it three months ago, because the credit spreads have tightened in. In order to meet some of the returns, you do have to go down in credit to make double digit type of returns achievable.They've done well in our portfolio. I would -- from a spread tightening standpoint. I would say from an amortization standpoint, the non-agency Resi 2.0 is probably not been as attractive an asset in the past because rates rallied down 50 basis points and made a lot of that product very, very refinanceable.

I noticed the treasuries changed ever so slightly in the last three or four days. Does that alter the way you're thinking about managing and balancing the portfolio or is it just a snap and now we're back into the same environment?

So if you're talking about just enhanced volatility in general, I think the last five months have been challenging. We managed the portfolio to a range. And we try to be very thoughtful and programmatic about how we think about staying within that range. And I think we telegraphed to the market consistently over the last two calls that we're trying to maintain a fairly neutral duration gap in part just given a lack of clarity around where rates might go. And so I can tell you that heading into an election year nothing has changed there.

Great. And congrats on all the work this quarter and giving us a fairly stable profile to fall back on. So thank you very much.

Thank you for the interest Henry.

Thank you. Ladies and gentlemen, at this time, there are no further questions. I'd like to turn the floor back to Jay for closing comments.

Great. Thanks, operator. Everyone, thank you for joining us in today's call. And we look forward to updating you soon on the fourth quarter results. Have a good night.

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.