Cherry Hill Mortgage Investment Corporation (CHMI) Q4 2019 Earnings Report, Transcript and Summary

Greeting. Welcome to the Cherry Hill Mortgage Investment Corporation's fourth quarter and full year 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]. As a reminder, this conference is being recorded.I would now like to turn the call over to your host, Rory Rumore of Cherry Hill. Please proceed.

We would like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's fourth 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, 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, 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 everyone to today's call. We are very pleased with Cherry Hill's fourth quarter and 2019 performance. The quarter saw moderating volatility as longer term rates moved awful lows witnessed over the summer, the yield curve steepened slightly and the mortgage basis improved. Prepayment speeds, however, remained elevated throughout the quarter as originators closed out a record year for origination volume. Despite the accelerated prepayments which caused headwinds, we successfully managed our portfolio and delivered another quarter of solid core earnings while expanding our book value. Overall, we are confident in the current composition of our investment portfolio and our investment team's risk management capabilities and believe we are well-positioned to capture additional opportunities to extend our success into 2020.Looking back on 2019, we encountered significant macroeconomic and geopolitical noise through much of the year. Broadly speaking, positive domestic economic data throughout the year was largely overshadowed by global trade disputes and the overhang of negative interest rates abroad, driven by tepid economic data from the EU and Asia. Largely due to the economic impact of the U.S.-China trade dispute, the Fed ended up shifting course and cut interest rates three times in the second half of the year. Our investment team navigated through that environment by actively managing our portfolio and utilizing a disciplined interest rate hedging strategy. As a result, we ended the year with our book value largely intact when compared to the prior year-end, which in our view was an excellent outcome given the various headwinds.Specifically for the fourth quarter of 2019, we grew book value per share by 2% to $17.35 and generated core earnings of $0.48. In addition, we posted a 4.4% economic return for the quarter, which brought our full year economic return to 8.8%, a meaningful accomplishment given the complex market environment we faced throughout the year. Meanwhile, we opportunistically began executing on our previously announced share repurchase program. As of December 31, we repurchased approximately $3.5 million of common stock. We remain confident in our strategy to deliver shareholder value over the long term while maintaining the ability to continue repurchasing shares as appropriate.As we think about 2020 thus far, the Coronavirus has gripped markets amid uncertainty around the impact on global productivity. This has led interest rates to hit record lows in recent days. Although we believe longer term the volatility will ultimately work its way through the system, we remain highly committed to being flexible and responsive to market swings to enable us to navigate any prepayment volatility as we did in the back half of 2019. We believe that we are properly positioned with our current asset composition and leverage and look to book value preservation and long term shareholder returns as our primary focus.More broadly in terms of our overall strategy, as we look forward into 2020, we remain committed to both our RMBS and MSR strategies and believe the two asset classes complement each other well and offer compelling returns in the low to mid-teens. Given our current size, we have been diligent about staying the course in that respect. On the MSR front, we will continue to be selective in building and structuring our MSR portfolio through attractive flow acquisitions and bulk purchases that fit our needs. At the same time on the RMBS side, we have a strong desire to mitigate our interest rate risk with respect to our agency portfolio through the purchase of specified pools that offer compelling refinance protection.As we have noted in the past, there are opportunities in the whole loan space that we believe would be accretive to shareholders and allow us to further diversify our business assuming we are in a position to grow the company. Ultimately, we will continue to be thoughtful in our approach to deploying capital and portfolio construction as we seek to create additional shareholder value.In short, I am proud the performance of our investment team for 2019, given the complex macroeconomic we encountered. We began the year with the 10-year pushing 2.70% in a benign prepay environment. As the 10-year plunged to 1.46%, prepayment speeds increased significantly. In addition, spread income compressed as the yield curve inverted during the summer putting additional pressure on earnings. Throughout that turbulent cycle, our team took actions to preserve book value utilizing a proactive hedging strategy. Just as importantly, we are positioned to build off last year and succeed in 2020 and beyond. We will continue to take a proactive approach towards managing our portfolio including continuing to add investments that will enable us to further withstand any increases in prepayment levels. We will also take advantage of opportunities that exist to add assets to the portfolio and reduce our overall risk exposure. We are excited for our future and are positioned well for another year of building value for shareholders as we continue to execute on our strategy.With that, I will turn the call over to Julian who will cover more detailed highlights of our portfolio and its performance over the quarter.

Thank you Jay. During the fourth quarter, U.S. and global rates rose even with the Fed delivering their third and final interest rate ease of 2019. The interest rate rise in the quarter can be attributed to optimism surrounding the reduction of the U.S. and China trade tensions, which ultimately resulted in the signing of a Phase 1 trade agreement in early 2020. Based on these themes, all spread sector assets including mortgages outperformed hedges as interest rates rose and volatility declined in the fourth quarter.As shown on slide five, servicing related investments comprised of full MSRs represented approximately 40% of our equity capital and approximately 10% of our investable assets excluding cash at quarter-end. Servicing assets increased as a percentage of equity from the previous quarter as improved MSR valuations increased the portfolio's market value as well as some selected additions we made to the portfolio.Meanwhile, our RMBS portfolio accounted for approximately 57% of our equity, a 5% decline from the previous quarter. As a percentage of investable assets, RMBS represented approximately 90% excluding cash at quarter-end. As of December 31, we held MSRs with the UPB of approximately $29 billion and a market value of approximately $291 million.Conventional and government MSR CPRs averaged approximately 22.3% and 15.5% respectively for the fourth quarter, both of which were marginally slower than in the prior quarter. The improvement in CPR speed is a function of interest rates and mortgage rates hitting low levels in September and rates subsequently bouncing to higher levels in November, December months, thus slowing prepayments. Additionally, winter seasonal and improved conventional recapture rates had an impact on speeds.As of December 31, the RMBS portfolio stood at approximately $2.7 billion as shown on slide seven. Quarter-over-quarter, the RMBS portfolio's composition continued to shift as capital was deployed. The 30-year securities position of the portfolio grew to 87%, up from approximately 85% as of September 30 and the remaining assets represented 13%. In the fourth quarter, the collateral composition of the RMBS portfolio posted a weighted average three-month CPR of approximately 11.3%.Prepayment speeds accelerated further in the fourth quarter as homeowners locked in lower mortgage rates in the third quarter when U.S. interest rates touched near term yearly lows. For the fourth quarter, we posted a 0.73% RMBS NIM versus a 0.87% NIM for the third quarter. The reduction in NIM was due to the increased amortization which resulted from faster prepayment speeds, which offset the reduction in the repo and swap costs.Near term, we expect the NIM to fluctuate but throughout 2020 we expect the NIM to maintain or improve based on continued improvements in asset financing levels, removal of higher cost interest rate swap positions and slower prepayments at the start of the year based on seasonals. The transition to improvement may take several months and the recent interest rate movements driven by the lack of clarity surrounding the Coronavirus may further delay this improvement.At quarter-end, the aggregate portfolio operated with leverage of approximately 6.1 times and a positive duration gap. We ended the quarter with an aggregate portfolio duration gap of a positive 0.11 years. As we move forward, we will continue to evaluate and alter the portfolio as necessary.I will now turn the call over to Mike for our fourth quarter financial discussion.

Thank you Julian. Our GAAP net income applicable to common stockholders for the fourth quarter was $5.2 million or $0.31 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 $11.8 million or $0.70 per share. Our core earnings were $8.1 million or $0.48 per share. As Jay mentioned, our book value as of December 31 was $17.35, an increase of $0.34 per share from September 30, or 2% net of the fourth quarter 2019 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 fourth quarter, we held interest rate swaps, swaptions, TBAs and treasury futures, all of which had a combined notional amount of $2.8 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 a component of the net gain or loss on interest rate derivatives.Operating expenses were $3.4 million for the quarter, of which approximately $688,000 was related to our taxable REIT subsidiary. On December 12, 2019, we declared a dividend of $0.40 per common share for the fourth quarter of 2019, which was paid on January 28, 2020. We also declared a dividend of $0.5125 per share on our 8.2% Series A cumulative redeemable preferred stock and a dividend of $0.515625 on our 8.25% Series B fixed to floating rate cumulative redeemable preferred stock, both of which were paid on January 15, 2020.At this time, we will open up the call for questions. Operator?

[Operator Instructions]. Our first question comes from Tim Hayes with B. Riley. Please proceed.

Hi guys. This is actually Mike, on for Tim. Congrats on a great quarter.

Hi Mike. How are you?

Good. Doing well. How are you?

Good.

So my first question is, what kind of levered returns are you seeing on MSRs versus RMBS?

Sure, I will let Ray answer that.

Sure. So on the MSR front, I think the levered returns are in the low to mid teens. Unlevered, high single digits. Yes, that's on flow.

And for the RMBS, we just take generic three-levered, let's say, about 10 times, you are looking something in the low to mid teens.

Got you. That's helpful. And then just given where your stock is trading on pro forma or the new book value, how do you think about investing in MSRs versus MBS versus buying back stock at these levels?

Well, a week ago, we were trading at 95% of old book. So that's a different discussion. But relative to the allocation between asset classes, Julian, I will let you take that.

Yes. Look, I think that we are continuously trying to figure out where the market wants to go in terms of absolute level of interest rates. The entry point, I think, for RMBS, specifically on some of the lower coupon mortgages, is somewhat attractive, if we are going to maintain at these rate levels over foreseeable period of time. If rates were or have the ability to rise over the curve steep and on out, we have to assess if this is probably a decent entry point for MSRs.

That's helpful. And then just some of your peers recently tried expand and get more active in credit. I know you hinted at this on the call but just given like the interest rate volatility, is this something you guys are taking a hard look at?

Yes. I would say that we get presented with a fair amount of opportunities in the space and I think for us to do something, one, it would have to be accretive to returns and two, it would have to be within the context of our experience and our ability to actually manage the asset. So when we think about that, we think about things more in the non-QM space than we do at the agency space. But as we do think about MSRs, we do think about origination, just generally speaking around how to come up with a recapture machine that helps.

That's helpful. And then just one other question. So as we are in the seasonally weaker months, I am just wondering how prepayments are looking so far in 1Q relative to historicals?

Definitely seeing a bit of a slowdown with the winter seasonals. Obviously, that also has driving rates typically 45-day lag. So what we are seeing in the market right now as far as levels of interest rate haven't really shown up in closings yet for originators.

And I would like to add a little thought in the sense that what we have seen, at least in the first couple months here, for the RMBS portfolio has been slower speeds out the gate, mainly based on seasonals. What we may start to see is, in the second quarter, as Ray kind of mentioned, things get locked in this month at these lower levels.

That's helpful. And then I will sneak one more in. Could you provide an intra-quarter book value update?

What I can tell you is that we looked to the book value on February 14 and on that date the book value was approximately flat.

That's helpful. Thank you for taking me question.

I am sorry. That's inclusive of two months of dividend.

Got you.

Our next question comes from Trevor Cranston with JMP. Please proceed with your question.

Follow-up on that last question.

Hi. How are you?

Good. So following up on the last question about the book value so far this quarter, understand that that update is as of mid-February. Can you guys give us a sense generically and I know things are moving around pretty quickly, but do you have a sense of how MSR prices have changed or performed over the last several days as rates have declined pretty sharply?

Just broadly speaking about relative to what we think about paying for MSRs? Or the valuation?

Yes, both. If you have color you could provide there would be helpful?

Well, we are predominantly buying flows. So we don't really have good color on anything related to bulk. And we haven't really seen a whole lot of trades in that space. But I think broadly speaking on the flow side, we have been taking down pricing on a regular basis.Ray, you have anything to add?

Yes. I would say that pricing remains relatively fair but keeping in mind that there is convexity adjustments to these grids. So as we see par rates get reset lower, obviously that's going to reflect in adjusters backing off price due to the market moves.

Yes. With respect to flow, we get to refresh pricing frequently. So we feel pretty good about our ability to keep pace.

Right. Got you. Okay. As you think about the outlook for prepays going forward, if rates were to stabilize around where they are at currently, can you give us a sense as to where your expectations are in terms of where speed on your portfolio would likely go relative to where they came in, say, for the fourth quarter of 2019?

Well, I mean obviously it's impossible to predict exactly where the CPRs are going to be in any given month. I would say that the portion of the portfolio that was highly refi-able since 6/30, we have seen a 20% decrease in that. Of course, some of that came back as recapture loans, as you saw the recapture rate did pop up. But the other thing to keep in mind is, the burnout on these are typically about 25% decrease each time they see a cycle of similar amount of incentive. So what the open item is, what does loans that had a 4.25% note rate was their first chance to really refi, well, you can't really say what that's going to do. Hard to say. It does appear that compared to previous cycles, that the refis pop up quicker but burnout faster as well.

Okay. That is helpful. And you guys mentioned that the recapture percentage went up in the fourth quarter. Can you provide any commentary around sort of if there is any additional room for improvements in that number, assuming we do see refis start to pick up again going forward? Or if sort of that 10% level where it came in is sort of a reasonable way to think about it going forward?

Yes. And keep in mind too that, that's quote of total payoffs. So there is always a portion of payoffs every month that are basically turnover, people just moving. So it's not really reasonable to capture much out of there. But in terms of recapture rate, we suspect that will be pretty much stable in the near term. We have enacted a more focused strategy on refi-ing the guys with the highest propensity to pay based on the payment savings. And we think that's shown an improvement from Q3 and Q4.

Okay. Got it. And then, sorry, I think that actually covered everything for me. Thanks.

Thanks Trevor.

Our next question comes from Henry Coffey with Wedbush. Please proceed with your question.

Yes. Two questions. You talked about a recapture arrangement. Those seem to only work if you own the person or the organization responsible for doing that. Is that feasible? Or would it be more of a partnership like you had in the past?

So the first thing I would say is, Ginnie recapture rates are very different than conventional recapture rates, as I think you know. And I think that with respect to the absolute number, we dig deeper and the portfolio is broken up by servicer and the collateral characteristics between the two servicers are different, given the collateral characteristics of each portfolio. We become increasingly more comfortable with their efforts to help us recapture our loans. And I would say that the RoundPoint portfolio has a higher gross note rate and we see a significantly higher recapture rate from them than we do Flagstar who has a lower gross note rate on their portfolio. So while the absolute number may not be impressive to you, we are pretty happy with the fact that the percentages are increasing and we look forward to be able to give you guys more color on the first quarter in a couple months.

So you are happy with the partnerships. They are actually working?

Look, do you always want more recapture, Henry? Sure. I think we would love to get every loan that we possibly could. I think originators are a lot more efficient about refinancing loans today than they were one or two years ago. But given the relationships that we have and the partnerships that we have and the communication around their efforts on our portfolio, we have gotten more comfortable with their efforts over the last six months. I can tell you six months ago, no, I wasn't very happy with it. But given the recent results that I have seen, I am much more comfortable.

So you don't have to go to the extreme of "buying somebody"? The partnerships are working. I guess the other question is --

Well, no, I didn't say that. But I think I alluded to the fact that if we looked at an originator, it would be with the goal of being able to do just that, which is to be more control of your recapture. And I think that is probably the best scenario you have. But at our size, what we have, we think, works well for us.

And then on the, it's a little shocking looking at where rates are. Forgetting what's going on in the MSR side, is there a reinvestment issue on the horizon for you? Or can you sort of live comfortably with where things are, with where your dividend is? Obviously, you have got a nice earnings buffer in there that wasn't there before. The yield curve is looking a little funky. When you look at rates today, is there a spread issue or reinvestment problem as you are putting your money to work?

Well, Henry, it's Julian. Clearly, we have come down to the low level of rates very quickly. I would not be surprised if some of this reverse just as quickly. It would be nice to always be able to put money to work, I think, at the higher levels of interest rates. Given where we are currently, we are able to put things to work in the mid teens. But you know, we will have to wait and see in terms of where prepayments, where financing costs as well as where swap rates kind of wind out. I think we feel comfortable where we are currently with our dividend and where our core expectations are at the current moment in time.

Great. Thank you.

Our next question comes from Kevin Barker with Piper Sandler. Please proceed with your question.

Hi. This is actually Pierce Dever, on for Kevin. So a lot of my questions have been answered but maybe a quick one on the buyback. I was just wanting to get a gauge of I guess your appetite to use the remaining $6.5 million or so, I guess it is, of authorization? And how you are thinking about deploying capital via this manner going forward?

Sure. So we believe that we put that program in place to execute it. I think we have had a few other things on our mind this week relative to just volatility in the marketplace. But at 80% to 85% of book, it's a compelling discussion. But I can't give you in absolute numbers what we do. I think we have had a lot of work to do this week just to keep on top of the markets. But to your point, we put the program in place. We have shown that we are willing to execute on it and we are just trying to be smart about how we do it.

Great. That's helpful. Thank you.

We have a follow-up question from Trevor Cranston with JMP. Please proceed you are your question.

Hi. Thanks. Just one more thing related to the movement in rates we have had recently. I know you guys have talked about being dynamic in your approach to hedging and trying to protect book value. Can you disclose any significant changes you have made to the hedge book or the portfolio since the end of the year? Thanks.

Yes. I will take some of that. We have made some changes. Obviously, throughout the rate rally, we have continuously adjusted this portfolio. It has not remained constant. I would say, some of the things that we have done, we have moved into lower coupon mortgages, a combination of TBA as well as spec pools. In addition, we have also taken the opportunity to reset some of our payer swap as interest rates have rallied. And in addition to that, we have also added duration via treasuries, futures.

Yes. I think our goal is pretty much unchanged, Trevor, which is to be fairly neutral, given the lack of conviction about where rates are going. That really hasn't changed.

Yes. Okay. That's helpful. Thank you.

At this time, I will like to turn the call back over to management for closing comments.

Great. Thank you everybody for joining us on today's call and we look forward to updating you soon on our first quarter results. Have a great evening.

This concludes today's teleconference. You may disconnect your lines at this time and have a great evening.