Cherry Hill Mortgage Investment Corporation (CHMI) Q3 2020 Earnings Report, Transcript and Summary

Greetings, and welcome to the Cherry Hill Mortgage Investment Corporation Third Quarter 2020 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Rory Rumore, Vice President of ICR. Please proceed.

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's Third Quarter 2020 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 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 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 hope you and your families are remaining safe and healthy, and we appreciate you joining us this afternoon. I want to thank our entire team for their continued hard work and dedication to manage through the ongoing challenges we face. The team continues to work remotely with no disruption to productivity. The third quarter saw the economy begin to rebound from the pandemic. But there remain considerable volatility with respect to political and macroeconomic factors during the quarter. U.S. GDP had a record third quarter bounce back, and equities continued to push higher as the economy reopened. But rates continue to remain at or near record lows throughout the quarter. We remain hopeful that a COVID vaccine will be forthcoming quickly, and our elected officials will eventually work together to rebuild this great nation, and create a more stable economic environment. In the absence of certainty, we continue to prioritize liquidity during the quarter and remained focused on our core RMBS and MSR portfolio strategies and competencies. Given our ongoing proactive approach to managing our portfolio, we continued to generate strong core earnings while maintaining a strong liquidity position. For the third quarter, we earned core income of $0.48 per share, well above our distribution level, and our current dividend yield is approximately 11%. We maintained lower leverage on our aggregate portfolio this quarter, ending the quarter at 4.6x leverage. And we also ended the quarter with $95 million in unrestricted cash on the balance sheet. To our expectation, that cash will be lower in the fourth quarter as we meet year-end servicing advances and navigate higher prepay speeds in our investment portfolio. We believe our portfolio remains poised to navigate the current environment and take advantage of select investment opportunities that present themselves. Our strategy of investing in MBS, combined with MSRs remains intact, with the majority of our invested capital deployed in MBS. Julian will provide some highlights on that portfolio shortly. Our Fannie and Freddie MSR portfolio continues to experience highly elevated prepayment speeds as expected, given the current interest rate environment. We anticipate this to be the case at least into 2021, given the historic level of mortgage refinances this year. We continue to rely on our flow program to acquire new MSR assets at yield levels we believe to be attractive. That market has shown signs of life of late and we expect to grow our market share over the coming months. Recapture efforts are a major focus as lower rates prevail, and we are working closely with our recapture partners to improve results on a regular basis. Forbearing statistics improved over the quarter and into the fourth quarter. As of the end of October, active forbearance remained just shy of 6%, with approximately 20% of borrowers having made all payments due through October. We continue to believe our bolstered liquidity position is sufficient to satisfy all our servicing advanced obligations over the foreseeable future. Apart from the strong core earnings and our strengthened liquidity position, book value per common share finished the quarter at $11.74 as of September 30. The large majority of the decline from June 30 is due to a reduction in the value of our deferred tax asset. Following the sale of our Ginnie Mae MSR portfolio at the end of the second quarter, we began to evaluate the size of our deferred tax asset versus our expectations. That effort resulted in the identification of an error in the calculation of our deferred tax asset. The error was not material to any single prior period in our historical financial statements but it required us to update certain financial numbers presented previously to correct the error, and we adjusted our book value this quarter to reflect the correction. To be very clear, the error and subsequent adjustment on our book value is not related in any way to the composition or valuation of our core RMBS or MSR portfolio. Thus, the adjustment had and will have no impact on our core earnings or the sustainability of our dividend. As we close out 2020, interest rates remain range bound as markets digest the election results and news on COVID spikes worldwide. The Fed recently reiterated its commitment in assisting the economy as necessary. But as it remains a very fluid environment, we remain content to keep some powder dry as we await further clarity. All in all, we remain squarely focused on proactively managing our portfolio, keeping our balance sheet and liquidity position strong to ensure we can take advantage of opportunities once we are past the pandemic. With that, I'll turn the call over to Julian, who will cover more details regarding the investment portfolio and its performance over the third quarter.

Thank you, Jay. During the third quarter, spread sector assets continued to steadily improve as the Fed policy remains accommodative and economies mostly reopened. Those policy actions allowed us to continue proactively adjusting our positioning to maintain our strong cash position. As we move past the election, the only certainty seems to be continued uncertainty with respect to the coronavirus as positive cases increase and the fact that we eagerly await news of a viable vaccine by the end of this year or early 2021. Servicing related investments comprised of full MSRs at approximately a UPB of $22 billion and a market value of approximately $163 million at quarter end. MSR investments represented approximately 29% of our equity capital and approximately 9% of our investable assets, excluding cash. Meanwhile, our RMBS portfolio accounted for approximately 45% of our equity. As a percentage of investable assets, RMBS represented approximately 90%, excluding cash at quarter end. Our conventional MSR CPRs averaged approximately 41% for the third quarter. Speeds remained elevated and were up from the second quarter, given the historically low interest in mortgage rate environment. The RMBS portfolio puts the weighted average 3-month CPR of approximately 14%, slightly above the prior period. Despite the slightly increased prepayment speeds, the RMBS speeds remained remarkably better than the Fannie Mae aggregate speeds for the quarter. As of September 30, the RMBS portfolio, inclusive of TBA, stood at approximately $1.6 billion. During the third quarter, we continued to reposition and delever our portfolio to maintain our liquidity position. Quarter-over-quarter, the 30-year securities position of the portfolio grew to 98%, up from 95% as of June 30. And the remaining assets represented 2%. For the third quarter, we posted a 2.23% RMBS net interest spread versus a 1.64% net interest spread reported for the second quarter. The improvement in spread was a combination of dollar roll income lower repo costs and resetting swap hedges to lower pay rates. During the quarter, our repo costs improved from 0.39% to 0.25%. As interest in mortgage rates remain at historically low levels, mortgage prepayment speeds will be a driver of the net interest spread as well as dollar roll income as we move forward. At quarter end, the aggregate portfolio operated with leverage of approximately 4.6x. We ended the quarter with an aggregate portfolio duration gap of a positive 0.2 years. We will continue to evaluate and alter the portfolio as necessary. I'll now turn the call over to Mike for our third quarter financial discussion.

Thank you, Julian. Our GAAP net loss applicable to common stockholders for the third quarter was $3.2 million or $0.19 per weighted average share outstanding during the quarter. While comprehensive loss attributable to common stockholders, which includes the mark-to-market of our held for sale RMBS, was $5.3 million or $0.31 per share. Our core earnings attributable to common stockholders were $8.2 million or $0.48 per share. Our book value per common share as of September 30 was $11.74 compared to the revised book value of $12.32 as of June 30, 2020. As Jay said, most of the book value reduction in the quarter was due to the recalculation of our deferred tax asset, which has no impact on our core earnings or the sustainability of our 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, TBAs and treasury futures, all of which had a combined notional amount of $1.9 billion. You can see more details with respect to our hedging strategy in our 10-Q as well as in the third quarter presentation. For GAAP purposes, we have not elected to apply hedge accounting for our interest rate derivatives. And as a result, we recorded the change in estimated fair value as a component of the net gain or loss on our interest rate derivatives. Operating expenses were $3.5 million for the quarter. On September 17, 2020, we declared a dividend of $0.27 per common share for the third quarter of 2020, which was paid in cash on October 27, 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 October 15. At this time, we will open up the call for questions. Operator?

[Operator Instructions] Your first question comes from the line of Henry Coffey with Wedbush.

It seems, as has always been the case with this market, that everything changed today. We saw all the mortgage names sell off. We saw all our credit sensitive names rally, et cetera, et cetera. Do you think there's something really durable going on here that could alter things like payment speeds and MSR values? And in your own view, can you give us a sense of where are we with rates and refinance activity? What -- how much of a rate increase could we see and still have a kind of the still red hot refinance market that we've been living with?

Henry, it's Jay. I'm happy to address that. Look, we think that a valid or credible vaccine will definitely have a meaningful impact relative to rates. We've also felt that the current results around the election that, that could also trigger a higher rate environment, just given what we think around the absolute level of stimulus that might come through the economy over the next year. But with respect to the question around what rate it's going to take. I think Ray would tell you, and he's next me so he could, but he would tell you that our 4.5% note rates and our 3.5% note rates are pretty much paying same speeds on the MSR portfolio. So we would need to see a rate sell off at a good bit from here to have a meaningful impact on speeds. And I say that because 5 mortgage companies didn't decide to go public because they thought the end of this was December of 2020. So we're optimistic -- we're cautiously optimistic about that. But understanding margins around originations and profit levels around the originators themselves, lead us to believe that there's still a ways to go before a meaningful decrease in speeds will happen.

Would a 4% mortgage coupon change things? Or does it need to be higher?

Clearly, yes, that would. Absolutely.

I mean, what, it's like -- we're at 3%. If you're getting a mortgage today, depending on who you talk to, you're paying 2.90% to -- in the 3s, low, low, low 3s, a 30-year fixed. Then if you have super credit and you're refinancing a low -- a high LTV house, you're going to do much better than that. That's why I say, is it 3.5% or is it 4% that really alters the market?

Yes. Clearly, 4% does. With respect to 3.5%, somewhere between 3.5% and 4% has a decent impact. But we would err on the higher side of that, just based on our view on origination relative to margins, primary, secondary spreads, et cetera.

Your next question comes from the line of Kevin Barker with Piper Sandler.

I was hoping you can give a little more detail on what happened with the deferred tax asset. How much was the write down? And what -- was that related to certain assets offsetting the servicing liabilities or something else that was calculated differently?

Sure. I'll let Mike take that, Kevin.

Kevin, yes. So we calculated the deferred tax asset the same way for the past few years. And with the sale of our Ginnie Mae MSRs after the sale, after it didn't produce the sort of reduction in the DTA that we were anticipating, we began to dig into what led to be an identification of an error in the calculation of that DTA. But as I noted in my remarks and as Jay noted in his remarks, the DTA isn't related to the value of the MSRs themselves or the RMBS income-producing assets. And so that error doesn't affect the ability to pay core earnings or the sustainability of the dividend.

Yes. And Kevin, I would add that the error occurred in booking the allocation of the sourcing fee and mark-to-market changes and the MSRs between Aurora and the QRS due to the intercompany sale of the excess MSRs.

Okay. And then does this have any impact on the taxes you're paying right now? Or you're going to pay in the future?

No, it doesn't. No. This is purely a deferred tax item, has nothing to do with current taxes.

And how much -- can you -- how much was the write down?

Broadly speaking, Kevin, it was -- the total book value dropped. About 1/3 of the drop was performance related, and about 2/3 was related to the DTA.

Okay. And then the CPR in the servicing portfolio is running much higher than the RMBS portfolio. Is there any desire to attempt to match those more or try to get those closer together, just given the economic hedges that they naturally provide?

There's definitely a desire. As I think I said in my notes that we're looking to have a bigger market share on the MSR side of the house. But I will tell you this, against my former comment to Henry, all of these guys that are looking to go public, aren't listing to go public with a statement to the market that 2020 is the last year for profitability. So we have been very careful about how we think about MSRs and the MSRs that have been added up later, probably right around just south of the 3% area in terms of note rate. And to us, that's compelling. So there is an interest here in kind of leveling that. But you just don't go out and offer a portion of your MSR portfolio for sale, the way you do with specific QSIPs on the MBS side.

[Operator Instructions] Your next question comes from the line of Mike Smyth with B. Riley FBR.

So on the $1.1 billion of MSRs, can you just talk a little bit about the acquisition? Was this bulk purchase or through the flow sale? And then what kind of multiple did you purchase it at? And is it all new production MSRs?

So it was all flow. And again, I think it's relative to our size, runoff and where we wanted to be, all things considered relative to our view on rates prior to today or the election. That was the number we were comfortable with historically, with the understanding that, clearly, we want to continue to purchase within the context of a good majority of what's running off. But we want to make smart decisions around servicing because it behaves more like TBA than specified pools. And as you all know, the TBA speeds are pretty high. So that's the first part. The second part is, think of it around 3 months, slightly less, but think about in a 3-month conversation.

Got you. That's helpful. And then so is that $1.1 billion during the third quarter? Or how much of that is subsequent to quarter end?

No, that's all just third quarter. I can tell you the...

All third quarter?

Yes. Fourth quarter has been pretty good so far.

Got you. That's helpful. And just kind of going off of that. Can you provide an intra-quarter book value update?

Yes. I would think of the value down somewhere between 1% and 2%.

Got you. Then another question, just given your cash balance and your kind of outlook for speeds in the investing environment, how do you think about buybacks or the use of capital just given your outlook for speeds, not necessarily based off of where you're trading on book value?

Right. Yes. So the MSRs are really what we think about the most related to cash. We've maintained that we have desire to maintain a strong cash position going into the year-end. And as you may or may not know, the fourth quarter is always the largest relative to the sourcing advances that are required to be paid relative to escrows. And given all things related to forbearance, it's our desire to make sure that we had a strong balance sheet going into that. As I said in my remarks also, as a result of using cash for all of that, plus dealing with the factor of merchant calls, et cetera on the MBS portfolio, I would expect cash to come down. But I think what we want to do is get through the fourth quarter, understand the implications of providing presidency, and we'll be in a better position to kind of give you an answer on where -- what we think about cash early on in the new year.

Your next question comes from the line of Trevor Cranston with JMP Securities.

Right. Just to follow-up on the question about the deferred tax asset write down. Can you say what the remaining size of the DTA is after the write down?

Sure. It's right about $20 million.

Okay. Got it. And then, I guess, as you follow-up on the previous questions about MSR acquisitions, as you think about the size of that portfolio going forward and where prepay speeds are, are you guys expecting the MSR portfolio to continue shrinking over the near term? Or do you think higher flow volume or maybe some bulk activity could offset the runoff? Just curious how to think about the size of that going forward.

Yes. So our goal, I think, going forward is to spend an amount on new acquisitions. That would be our goal on a go-forward basis. And to the extent that we have some opportunities to buy MSRs at a level that we find compelling, that would be above that. I think we would be in a position to do that, too, once we get through the year.

Got it. Okay. And then as you guys are making new investments or reinvestments in the agency book, can you comment on what kind of coupons or what stores you like in the spec pool market and kind of where you see levered returns on new agency investments?

Thanks, Trevor, it's Julian. In terms of the coupons that we have been buying, I think we've been, like some of the other REITs playing dollar roll income. So we've been buying 2s and 2.5s in the portfolio. I would say the majority of our t's in the portfolio are all TBA at this point. That return is probably mid-teens. In terms of, like, 2.5, it's a combination of spec pools as well as dollar roll income. And I would say that, that will probably range in the low to mid-teens.

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, operator. Thank you very much, everyone, for joining us on this call. And we look forward to updating you on our fourth quarter call next year. Have a great end of the year.

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