MFA Financial, Inc. (MFA) Q1 2016 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the MFA Financial Inc. First Quarter Earnings Call. At this time, all participants are in listen-only mode. Later, there will be an opportunity for your questions and instructions will be given at that time. [Operator Instructions] As a reminder, today’s conference is being recorded. I would now like to turn the conference over to Ms. Danielle Rosatelli. Please go ahead.

Good morning. The information discussed on this conference call today may contain or refer to forward-looking statements regarding MFA Financial Inc., which reflects management’s beliefs, expectations and assumptions as to MFA’s future performance and operation. When used statements that are not historical in nature including those containing words such as will, believe, expect, anticipate, estimate, should, could, would, or similar expressions are intended to identify forward-looking statements. All forward-looking statements speak only as of the date on which they are made. These types of statements are subject to various known and unknown risks, uncertainties, assumptions, and other factors, including those described in MFA’s Annual Report on Form 10-K for the year ended December 31, 2015, and other reports that it may file from time-to-time with the Securities and Exchange Commission. These risks, uncertainties and other factors could cause MFA’s actual results to differ materially from those projected, expressed or implied in any forward-looking statements it makes. For additional information regarding MFA’s use of forward-looking statements, please see the relevant disclosure in the press release announcing MFA’s first quarter 2016 financial results. Thank you for your time. I would now like to turn this call over to Bill Gorin, MFA’s Chief Executive Officer.

Thanks very much, Danielle. I would like to welcome everyone to MFA’s first quarter 2016 financial results webcast. With me today are Craig Knutson, MFA’s President and Chief Operating Officer; Gudmundur Kristjansson, Senior Vice President; Bryan Wulfsohn, Senior Vice President; Steve Yarad, CFO; and other members of Senior Management. In 2016, we continued to execute our strategy of targeted investment within our residential mortgage asset universe. As opportunities in the residential mortgage asset sector are identified, MFA has the focus and the requisite capabilities to analyze the investment and to be a significant investor. Turning to Page 3. Despite the low interest rate environment, we continued to identify and acquire attractive credit sensitive residential mortgage assets, such as credit sensitive loans and three-year step-up RPL/NPL securities. In the first quarter of 2016, we generated net income of $74.3 million, or $0.20 per common share. The dividend was again $0.20 per share. Book value per common share at March 31 was $7.17. Turning to Page 4. MFA began operations nearly 18 years ago, and we generated strong long-term returns to investors through volatile markets and through various interest rate and credit cycles. Since 2000, we generated annualized shareholder returns of approximately 14%, and over the last 10 years have generated annualized shareholder returns of 13%. Turning to Page 5. We again lay out MFA’s strategy for 2016. We continue to focus on high value-added credit sensitive residential mortgage assets. The credit assets we’ve acquired continue to perform well and tend to have less interest rate sensitivity. Our strategy does require staying power, which gives us the ability to invest in and hold long-term distressed, less liquid assets. I think you will see an example of that in this quarter, where we did have some negative marks in the first quarter on our Legacy Non-Agencies, but in the second quarter they’ve already reversed. So this is an example of making the right investments, make sure the assets perform well, and have the staying power to hold these assets. We have permanent equity capital. Our debt-to-equity ratio of 3.4 times is low enough to accommodate potential changes in marks. We’re able to invest significant amounts at advantageous prices, while other investors may be facing capital outflows. Just as a reminder, we are internally advised and compensation is not tied to the size of our portfolio. Turning to Page 6. Our mortgage assets run off due to amortization, paydowns or sale, allowing reinvestment opportunities in changing interest rate and credit environments. Credit spreads widened mid-quarter in the first quarter and we were a buyer of loans, three-year step-up RPL/NPL securities, credit risk transfers, and Legacy Non-Agency MBS. In the quarter, our re-performing/non-performing loan portfolio grew, and our three-year step-up portfolio would have been about flat, but for some sizable bond redemptions at the very end of the quarter. We did not acquire any Agency MBS in this quarter. Turning to Page 7. As you can see MFA’s yields and spreads remain attractive and relatively consistent despite the changing interest rate environment. Turning to Page 8. We represent yields and spreads for our more significant holdings. Given the leverage we are utilizing or may utilize in the future, each of these asset types are generating attractive returns to our shareholders. Turning to Page 9. Our undistributed REIT taxable income stood at $0.17 per share as of March 31, 2016. We currently estimate that the amount per share may grow somewhat in the second quarter due to an expected countrywide settlement. Turning to Page 10, Gudmundur will present update on MFA’s interest rate sensitivity and on the following two pages present details of the first quarter change in book value.

Thanks, Bill. On Slide 10, if we look at the interest rate sensitivity of MFA’s assets and liabilities, MFA’s asset duration declined 10 basis points in the quarter to 132 basis points at the end of the quarter, as the interest rates declined by approximately 50 basis points in the quarter. The notional amount of our swap hedges remained approximately unchanged at $3 billion at the end of the first quarter, but the hedge duration declined 10 basis points to minus 3.3 at the end of the quarter, as our swap hedges shortened naturally over time. In aggregate, MFA’s net duration was almost unchanged at 55 basis points at quarter end. We continue to pursue a strategy of limiting the impact of interest rate changes to our book value by maintaining net portfolio duration below one and limiting the impact of changes in long-term interest rates by preferring shorter credit sensitive assets at the NPL/RPL MBS and credit sensitive whole loans. Turning to Page 11. Book value per share declined approximately 4% in the quarter. This is due primarily to the impact of changes in fair value of Legacy Non-Agency MBS and swap hedges. As you know, net income and dividends were both $0.20 per share in the quarter. Agency MBS market prices increased modestly, positively impacting book value by $0.03 per share. The net change in book value per share attributable to Non-Agency MBS and CRT securities was approximately negative $0.19 per share. Medium-term interest rates declined by about 50 basis points in the quarter, negatively impacting the market value of our interest rate hedges by about $0.14 per share. Keep in mind that the purpose of our interest rate hedges is to hedge the interest rate risk on both our Agency and Non-Agency MBS, including changes to funding costs due to hedge fund increases. Turning to Page 12. We’ll do a deeper dive into the change in book value due to Non-Agency MBS. You can see that negative $0.12 of this change was due to the impact of change in market prices, which is consistent with a small amount of spread widening in the first quarter. Since quarter end, spreads on Non-Agency MBS have tightened to similar levels we saw at the end of 2015, reversing the bulk of the book value decline due to lower Non-Agency MBS prices that we experienced in the first quarter. Realized gains of $0.03 per share were included in net income and were distributed to shareholders. Discount accretion, which is basically income in excess of coupon on Non-Agency MBS purchased at a discount was approximately $0.06 per share. This is included in income and is also included in distributions to shareholders. Finally, principal paydowns in excess of the market value increased book value and realized losses decreased face amount of Non-Agency MBS and reduced book value. With that, I will now turn the call over to Craig Knutson, who will discuss our credit investments in greater detail.

Thank you, Gudmundur. Turning to Page 13, although the general health of the U.S. economy is a subject of much debate these days, the residential mortgage credit market enjoys unequivocal fundamental and technical support. The labor market and employment numbers continue to improve, interest rates and mortgage rates remain very well, sales of existing homes rose over 5% to $5.33 million in March of this year and median existing single-family home prices are up 5.8% year-over-year. According to a recent CoreLogic National Foreclosure Report, the US National Foreclosure rate is now down to 1.1%. This is the level that we last saw in November of 2007, and foreclosure inventory is down almost 24% in the last year. Seriously delinquent that is 90-plus days, mortgages are down to 3.2%, again the lowest since November of 2007, and only 8.5% of all residential properties with the mortgage have negative equity today. Turning to Page 14. We made good progress growing our credit sensitive residential whole loan portfolio in the first quarter increasing this asset class to over $1 billion. In addition, we bought another loan package in April approximately $100 million, that is expected to settle in early June. The supply picture for the balance of the year looks promising with continued selling expected from GSE’s, large banks, and other market participants. And just as a reminder, these residential whole loans are qualifying interests for purposes of the re-qualification and 1940 Act exemption. Moving to Page 15. Our credit sensitive whole loans appear on our balance sheet on two lines; loans held at carrying value, $376 million, and loans held at fair value, $647 million. This election is permanent and it’s made at the time of acquisition. Typically, we elect carrying value for re-performing loans and fair value for non-performing loans. Non-performing loans generally follow one of two paths as we work with borrowers through our services. Either the loans begin to re-perform perhaps after some loan modifications, but we take possession of the property and eventually sell the property, because timelines are difficult to predict and not discreet, it is somewhat challenging to measure results, at least, prior to liquidation. That said, our early results indicate to us that our returns appear to be consistent with our expectation of returns over time of between 5% and 7%. We currently have borrowing through three warehouse lines with aggregate borrowing of almost $600 million and we are in the process of opening a fourth warehouse line. Once completed, we’ll look to add some leverage on the de-performing loans that have not been financed with leverage to-date. We’ve also added additional staff and implemented technology solutions to help with the asset management function associated with this portfolio. We are excited to have the ability to oversee servicing decisions on troubled loans, and we believe that we can achieve improved returns on these loans through thoughtful and diligent asset management. Turning to Page 16. We purchased approximately $300 million of RPL/NPL mortgage-backed securities in the first quarter, but this asset class actually declined during the quarter by $130 million. As Bill mentioned previously, this was due to a large paydown that occurred at the end of March. We’ve already added a little over $200 million of new bonds since the end of the quarter at attractive yields. We continue to like these assets due to their low sensitivity to interest rates than what we believe to be low credit risk, while at the same time providing low double-digit ROE’s. Spreads on new issued deals have widened somewhat recently and we’ve been able to invest at attractive yields in some cases as high as 4.5% recently. Moving to Page 17. The credit metrics on the loans underlying our Legacy Non-Agency portfolio continued to improve. 81% of the loans underlying this portfolio are now amortizing. This principal amortization together with home price appreciation continue to reduce LTVs. Delinquencies are curing. 60-plus day delinquencies, as of March 31 for the portfolio have declined to 13.1%. On this page, we illustrate the LTV distribution of current loans in this portfolio. The red bars on the right represents at risk loans, where the homeowner owes more on the mortgage than the property is worth. These are the loans we worry most about transitioning to delinquent in the future, because of the fact that these borrowers are underwater. As you can see, these red bars are disappearing. Please note also, the increasingly large green bars on the left side, loans with LTVs below 80% are attractive refinancing candidates and a combination of low rates available today and a 30-year amortization term on a new loan versus the 20-year remaining term on these existing loans can offer homeowners in some cases substantially lower monthly payments. And, of course, given our deeply discounted purchase prices of these assets, we are very happy when the underlying loans prepay. And I’d now like to turn the call back over to Bill.

Thanks, Craig. So in summary, we continue to utilize our expertise to identify and acquire attractive credit sensitive residential mortgage assets. In the quarter, we continued to acquire credit sensitive mortgage loans and three-year step-up RPL/NPL securities. Credit sensitive assets are performing well, and we believe with our duration in our hedges, we are well positioned for changes in monetary policy and/or interest rates. This completes today’s presentation. Operator, could you please open up the lines for questions?

[Operator Instructions] And our first question is from the line of Jessica Ribner with FBR & Company. Please go ahead.

Good morning. Thanks for taking my question.

Sue.

Just in terms of, how you are going to go – going forward, how you are going to acquire assets? Are you looking at the auctions in the distressed space, and if so, what kind of competition have you guys been seeing?

When you say options, you mean call options?

Mentioned auctions I think.

Oh, auctions.

Auctions, auctions?

Okay. So the supply picture really has not changed all that much over the last year or so. I think the market participants are generally the same. And as you know, when we are bidding on whole loan packages, they tend to trade in the larger pieces, and unlike new issue deals where a number of participants maybe be able to get an allocation and buy bonds, in whole loans, there’s only one winner. So I think the acquisitions are maybe a little bit more lumpy. But I think, we pretty much have been able to add those assets consistently over the last year or so. Some quarters obviously will be a little heavier than others.

And the flow that you foresee?

The flow that we foresee is similar to what we saw last year. I think $35 billion or so traded in 2015, and we expect 2016 to be roughly equivalent.

All right. Thank you. And in terms of just the recent market dislocation, have you seen any, kind of, really attractive opportunities coming loose maybe in the non-auction, small bank, or bank space that you foresee taking advantage of, or is that still been pretty quiet?

This is Bryan. It’s still been relatively quiet. We tend to see some of those opportunities but they’re usually smaller in size. So, just maybe in the area of $20 million to $50 million versus $100 million to $300 million packages coming from big banks and GSEs.

All right. Thank you so much.

Thank you.

Question from Steve DeLaney with JMP Securities. Please go ahead.

Hi, good morning, everyone. Thanks for the question. Bill, you’re sounding good, great to hear.

Thank you.

Just wanted to touch on the agency portfolio you show on Page 6, but it’s in pretty much in run-off mode, and then in Page 8, we’re looking at $4.5 billion of the portfolio that’s got an 80 basis point spread and 8 times levered. So I’m sure this is something that within the office, you guys are always talking about. But are you look – when you’re looking at these other opportunities, especially the whole loans, which obviously work for you in terms of the 40 Act Exemption, are you tempted to accelerate the reallocation of capital away from that agency portfolio into some of these credit investments? That would seem to be the – when I look at your balance sheet today, that would seem like the biggest source of flexibility or change if you were interested in moving to sort of a higher ROE profile on that capital?

So we really have not been selling the Agency assets and sort of allowed it to run off. And your are right, if there was a very, very large compelling investment opportunity, as long as we have enough qualifying real estate assets, it’s not Agency whole pools, it’s qualifying real estate assets. For the 40 Act, we could consider a reallocation. But right now, it’s sort of been orderly growth on the loan side and orderly run off on the Agency side. But we do look at it, but there has been no concurrent reason to change the allocation.

Got it. I guess it, like what happened in February, and I think you were able to buy $40 some million of legacy paper. If we would have – fingers crossed, we don’t have that event again, but if we did, is that the type of thing, if that – a bigger opportunity there would be the kind of thing that might compel you to actually pull the trigger and sell some agencies?

It is, and just going back to the strategy, we said fingers crossed, we do have disruptions.

Yes exactly, especially when you have liquidity and flexibility for sure. And just one final thing. There was that interesting transaction that Chase did 26-1, and I guess the new acronym is PRT, Portfolio Risk Transfer. Just curious, I think one of the other mortgage REITs indicated, they actually – they played in that, I guess in the B class. And curious if you guys look that and if you see those kind of private risk transfers as another area that you might look at down the road? Thanks.

I’m going to let Gudmundur to answer that, but it actually, in the middle of February, some of the best opportunities were in the Agency credit risk transfers. We actually grew the portfolio some within that as we really saw the widening. Gudmundur, you want to add JPMorgan?

Yes. I mean, this is just a further – not necessarily a new asset class, but it’s a development of the Non-Agency space, where you see these risk transfers and people trying to do different types of risk transferring. The Agencies have always tired to do the CRTs, they tried all the structures, and JPMorgan here in this case is trying to do a risk transfer deal, where they get more favorable regular treatment on the loans that they hold, right. So, we looked at the structure, I mean, relative to the CRTs, it seems to price somewhere close to what you can do there, and so we’re aware of it, we didn’t play in it. But we’re very familiar with the structure and back to those clients, during February and in the first quarter, the spreads were widening, we were adding some CRTs, as you saw in the quarter.

Yes. Okay, appreciate the comments, guys. Thanks.

Question from Bose George with KBW. Please go ahead.

Hey, guys. Good morning. Just in terms of incremental returns on some of those asset classes that you are favoring, how does it compared to a few months ago?

Well, when you say a few months ago, do you mean middle of February or…

No, the year, actually this year?

Going back to December, the spreads – I think, as Gudmundur mentioned in the phone call, the spreads were about consistent with year-end.

And how about just with what you have in the existing portfolio? I’m just wondering if there is any sort of incremental upside as you deploy some capital into those assets.

I think the one place we are seeing a little bit better opportunity might be the RPL/NPL securities, clearly the coupons have trended up over time. In the quarter, I think, Craig mentioned that in April, we acquired a good amount of the RPL/NPL securities. Well, would you say the average coupon was in excess of 4%?

Yes, I think, it was at least probably four and three eighths.

So that’s….

Some of those also had two-year step-ups as opposed to the three-year step-up.

So we are seeing some increase in the average yield on the RPL/NTL securities.

Okay, great. Thanks. And then, just in terms of the sellers of the whole loans, is that big banks GSEs any color on who is selling those?

I mean, you know the names. I mean they’re all, I mean, you said it right there. It’s the big banks and the GSEs and I cannot go into specific name.

Okay, great. Thank you.

Sure.

Question from Joel Houck with Wells Fargo. Please go ahead.

All right. Thanks for taking the question, guys. Are you surprised that the, given the volatility that occurred in Q1, when you look at Page 6, the CRT securities are actually up slightly at the legacy, the mark was down. You said that legacy, I guess, was largely recovered with the spread narrowing. But our understanding was the CRT had a lot more volatility. So maybe the second question or a corollary is, is there something unique to your legacy RMBS that perhaps we are not picking up?

I would say, it’s not a question of the uniqueness. The spreads on the CRTs, there is absolutely no change in the credit during the quarter, as you – you just see the technicals more.

And, Joel, also keep in mind, what you’re seeing is a snapshot at the end of the quarter. So you are absolutely right. The CRTs did exhibit a largest spread walls [ph] during the quarter, especially in the middle of the quarter, in early and middle of February, spreads in CRTs gotten really wide and much wider than on our Legacy Non-Agency. So just keep in mind, it’s a snapshot at the end of the quarter and at the beginning of the quarter.

Joel, one other thing to add, if you look at our CRT portfolio, the majority of those are from earlier vintages, the 2013, 2014. So I think where you saw the most volatility in prices was on newer production CRT. So, it may be ironically that our CRT portfolio is a little bit different than maybe the average CRT market in general.

Yes, that – okay, that makes sense to me. Now, if you, obviously you are allocating more toward credit, and it seems like the consistent theme here is that returns are higher on CRT and step-ups. Are you – and you see the run off of a $192 million in Legacy Non-Agency. Is that something that you desire as to kind of let the legacy book run off more and deploy it into the CRT and the step-ups?

Well, you need to keep in mind that ignoring MFA, the entire universe of Legacy Non-Agency is declining at a rapid pace.

Right.

So run off is almost unavoidable. People that have the assets and they are happy with the assets really can’t keep the portfolio in place.

But you’re not looking to replace that run off aggressively, I guess is the question, with buying – going out and just buying paper to replace. You’d rather do the newer stuff?

That is correct. It requires a disruption process in order to be able to grow in size on the legacy. It’s a shrinking universe. It’s actually difficult to assemble large pieces of the higher quality legacy non-MBS that exist in our portfolio. It’s rate that you see a large piece trade now.

All right. Thanks, guys.

Thank you.

We have a question from Doug Harter with Credit Suisse.

Thanks. Can you talk about what your expected pace of future – near-term run off is on the RPL/NPL portfolio, or do you expect any more big redemptions?

On the securities portfolio?

Yes.

No, I think it was $300 million that ran off, no, it was $400 million that ran off in the first quarter. I would say that was probably a little bit higher than expected. But in general, it’s probably $300 million plus or minus a $100 million a quarter.

But these assets are typically callable after one year?

Correct.

So you don’t really control if the market change in RPL/NPL securities rather than pricing coupons in excess of four, price the coupons three handle, there probably would be more calls, so it’s hard to predict?

Also Doug, when we feel you do get calls typically the issuer does the re-lever with the collateral. So it’s actually not as difficult as you might think to replace that, because you can typically buy bonds in the new deal and the new re-lever.

Got it. But I guess what you’re saying prior like the deals – the securities you bought this quarter have been at wider spreads, so you probably have actually would prefer it if you saw more of that in these current spreads?

Yes, we can replace three and five eighths yields with four and three eighths yields, that’s pretty easy.

Right. Okay. That make sense. All right. Thank you.

Sure.

Thank you.

[Operator Instructions] We’ll go to the line of Rick Shane with JPMorgan. Please go ahead.

Good morning, guys, and thanks for taking my question. Most have been asked and answered at this point. But would be curious given your – the breadth of your exposure, if you are seeing anything in – our view is that, housing credit is fundamentally strong and you guys pointed out sort of comparable all the way back to 2007 levels, which is a good sign. Curious if you’re seeing any pockets of weakness on an MFA level at this point given some of the economic events we are seeing?

No, I don’t think we are at all. At the end of the day, LTV is sort of the strongest credit metric. So for instance, we’ve looked at exposure to oil patch and if you look at the home price appreciation that’s occurred to those seasoned loans in those portfolios, there has been so much home price appreciation that the LTV’s are low enough that, even if someone did lose their job and couldn’t make mortgage payments, they have equity in their homes, so they’d sell the house and payoff the mortgage.

Got it. And you’re not – and again, look, it doesn’t look like there’s a big labor issue in those markets at this point, but you’re not seeing any signs of those housing market starting to reverse or soften related to that. Are you?

Not yet, but it certainly could be the case. But again, the low LTVs are really what insulate us to a large extent from small moves in home prices.

Well, just as an example, Craig. Within our credit loans and our RPL/NPL securities, what percentage of the assets are in entirety of Texas?

Oh, I think less than 2%.

I mean, so less than 2% in the entirety of Texas, we’re not just talking about Houston.

Got it. That’s helpful context. Thank you, guys.

Thank you.

Sure, Rick.

At this time, there are no further questions in queue.

Thank you, operator. Well, I want to thank everyone for joining us today, and we look forward to speaking to you again next quarter.

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