MFA Financial, Inc. (MFA) Q3 2016 Earnings Report, Transcript and Summary

Ladies and gentlemen, good morning, thank you for standing by and welcome to the MFA Financial Incorporated Third Quarter Earnings Conference Call. At this time, all lines are in a 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 Danielle Rosatelli to read the forward-looking statement. 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 operations. 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 making. 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 in mix. For additional information regarding MFA's use of forward-looking statements, please see the relevant disclosure in the press release announcing MFA's third 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, Danielle. I'd like to welcome everyone to MFA's third 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; Terry Meyers, Senior VP and Director of Tax; and other members of Senior Management. In the year, we continued to execute our strategy of selective investment within the entire residential mortgage universe. We have many years of experience in analyzing and investing in such assets, and thanks to our permanent capital REIT structure, we have the staying power to hold these assets throughout fluctuations in market value. Turning the page 3, despite the period of extremely low interest rates, we remain well positioned to generate attractive returns. Interest rates are being held on the worldwide basis by accommodative monetary policy, low economic growth rates, international funds flows, demographic factors and a bias towards low inflation. In this environment, we continue to identify and acquire attractive credit-sensitive residential mortgage assets such as three-year step-up securities and credit-sensitive residential home loans. In the third quarter of 2016, we generated net income of $79.3 million, or $0.21 per common share. The dividend was again $0.20 per share, and book value per common share at September 30 increased to $7.64. Turning to page 4, we began operations nearly 18 years ago and the Company has generated strong long-term returns to investors through volatile markets, through various interest rate and various credit cycles. Since 2000, we've generated annualized shareholder returns of approximately 15%, over the last 10 years, have generated annualized shareholder returns of approximately 13%. Turn to page 5, we lay out our strategy for 2016. Continued focus on high value-added credit-sensitive residential mortgage assets. The assets we required continue to perform well and tend to have less interest rate sensitivity. These assets are typically purchased at a discount so they actually benefit from increases in prepay rates. The strategy does require staying power, which gives us the ability to invest in and hold long-term distressed, less-liquid assets. We have permanent equity capital. Our debt-to-equity ratio actually trended down the quarter, primarily due to growth in stockholders' equity and its 3.1, which is low enough to accommodate potential declines in marks. MFA is able to invest significant amounts at advantageous prices, while other investors may be facing redemptions and other capital outflows. As a reminder, we're internally advised and our compensation is not tied to our size. 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. In the third quarter, we were a buyer of three-year step up securities, residential loans, CRTs, and legacy non-agency MBS. In the quarter, our re-performing/non-performing loan portfolio and our holdings of credit risk transfer securities each grew. While we were a very active buyer of three-year step-up securities, our investment in this asset class actually declined somewhat due to paydowns and bond redemptions. We consistently believe these step-up securities to be very short-term assets, with low interest rate sensitivity. We do not -- as usual, we did not acquire any agency MBS in the quarter. Turning to Page 7, as you can see, despite changing markets, our yield and spreads remain attractive and relatively consistent despite this interest rate environment. Turning to Page 8, here we present yields and spreads for our more significant holdings. Given the leverage we're utilizing, or may utilize in the future, each of these asset types generates attractive returns to MFA shareholders. Turning to Page 9, Terry Meyers will provide an update on undistributed REIT taxable income.

Thank you, Bill. As you can see from page 9, as of September 30, 2016, we estimate MFA had undistributed REIT taxable income of approximately $0.16 per share. The Company has until the filing of its 2016 return, that's due not later than September 15, 2017, to declare the distribution of any 2016 REIT taxable income not previously distributed. In addition, an unwind of our remaining resecuritization transaction is expected to occur in the first quarter of 2017, with the expected results that will generate taxable income, but not GAAP income, of an amount estimated to exceed $0.10 per share. I'll turn it back to Bill now.

Thanks. Actually, Gudmundur will present the next couple of pages.

Thank you, Bill. Turning to page 10, we review the interest rate sensitivity of MFA's assets and liabilities, MFA's overall interest sensitivity remains low and it was little changed in the quarter. The duration of our assets was unchanged in the quarter at 122 basis points, while the duration of our interest rate hedges declined 20 basis points in the quarter as we did not add any new hedges in the quarter and the duration of our existing swaps declined naturally over time. The notional amount of swaps remained unchanged at the end of the third quarter at $3 billion. Net duration changed little in the quarter, increasing 5 basis points to 55 basis points at the end of the third quarter. MFA continues to pursue a strategy of maintaining low sensitivity to interest rates, but preferring short credit sensitive assets. Focusing just on our assets, excluding any hedges, you can see that our assets have a duration of only 122 basis points and none of our asset categories have an estimated duration longer than three years. With limited sensitivity to longer term interest rates and the fact that 73% of our MBS are adjustable, hybrid or step-up, we believe our assets will continue to perform well if interest rates continue to rise modestly in the third and the fourth quarter. In addition, with the inclusion of $3 billion swap hedges that are positively impacted when the fed raised interest rates. And when rates rise in general, we believe MFA is well-positioned to weather an uncertain interfered landscape going forward. Turning to Page 11, we show the magnitude of MFA's agency MBS premium amortization and legacy non-agency MBS discount accretion since 2013. As we can see, the discount accretion has been double the premium amortization in most quarters during this period. This is primarily due to the fact that the legacy non-agency MBS purchase discount of approximately 27 points is much larger than the agency MBS premium amount of approximately four points. Because of this and the fact that pre-payment rates on the two asset classes tend to trend together, we do not believe that an increase in prepayments would negatively impact MFA's earnings. With that, I will turn the call over to our President and Chief Operating Officer, Craig Knutson, who will talk about our credit assets and credit fundamentals in more detail.

Thank you, Gudmundur. Moving to page 12, the residential mortgage credit market enjoys unequivocal, fundamental and technical support. According to the most recent report from the National Association of Realtors on existing home sales, distressed sales as a share of existing home sales are now only 4% of those existing home sales. Distressed sales represented 10% of existing home sales just a year ago, and they represented 30% of existing home sales five years ago. Interest rates and mortgage rates remain very low. Median, existing single-family home prices are up 5.6% year-over-year and housing inventory continues to decline. According to a recent CoreLogic national foreclosure report, foreclosure inventory is down 30% in the last year. Now clearing out foreclosure inventory is an important step in producing home price appreciation as distressed inventory levels tend to hold prices down. In addition, borrowers with equity in their homes are less likely to default in the future and can also refinance their mortgages at low current rates, which generates prepayments on our existing loans. Moving to Page 13, we had a very successful quarter on the RPL and NPL home loan front, with several trades totaling $312 million. The supply picture for the balance of 2016 and 2017 looks promising, with continued selling expected from GSEs, large banks, and other market participants. Turning to page 14, our credit sensitive home loans appear on our balance sheet on two lines; loans held at carrying value, $551 million; and loans held at fair value, $797 million. This election is permanent and is made at the time of acquisition. Typically, we elect carrying value for re-performing loans and fair value for non-performing loans. Our September 30 balance sheet includes two home loan trades recorded on their respective trade dates that had not yet settled as of September 30. These trades settled in October were both funded through existing warehouse lines. We currently have borrowing through four warehouse lines with aggregate borrowings of approximately $630 million and we're in the process of opening a fifth warehouse line. Our asset management team is actively managing delinquent loans in REO properties together with our services in order to enhance outcomes on these property liquidations. Turning to Page 15, we purchased approximately $375 million of three-year step-up securities in the third quarter. We continue to like these assets due to their low sensitivity to interest rates and what we believe to be low credit risk. Despite their very short duration, we have seen some modest price appreciation in this asset class as heavy buyer interest has pushed yields lower on new issue deal. With yields in the mid-3s, these assets still produced levered returns in the high-single digits. Moving to Page 16, the credit metrics on the loans underlying our legacy non-agency portfolio continue to improve. 86% of the loans underlying our legacy non-agency portfolio are now amortizing. This principal amortization, together with home price appreciation, continues to reduce LTVs. Delinquencies are also curing. 60 plus day delinquencies as of September 30 for the portfolio have declined to 12.5%. On this page, we illustrate the LTV distribution of current loans in the portfolio. The red bars on the right hand side represent at-risk loans where the homeowner owes more on the mortgage than the property is worth. These are the loans we potentially worry most about transitioning to delinquent and defaulting in the future because the borrowers are underwater. As you can see, these red bars are disappearing. Please also note the increasingly large green bars on the left hand side. These are loans of LTVs below 80% and are very attractive refinancing candidates. And 78% of the current loan now has LTVs of 80% or lower. 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 loan can offer homeowners substantially lower monthly payments. And of course, given our deeply discounted purchase price for these assets, we're very happy when the underlying loans prepay. And with that, I'd like to turn the call back over to Bill.

Thanks, Craig. Turning to Page 17, to summarize, we continue to identify and acquire attractive credit sensitive residential mortgage assets. In the third quarter in particular, our investments were in three-year step-up securities and credit sensitive mortgage loans. As Craig has pointed out, our credit sensitive assets continue to perform well, it basically we have since we've acquired them. As Gudmundur pointed out, we're well positioned for changes in prepay rates, changes in the monetary policy and our interest rates. That completes today's presentation. Operator, if you're there, could you please open up the lines for questions?

Yes. Thank you. [Operator Instructions] Our first question today comes from the line of Bose George with KBW. Please go ahead.

Thanks, good morning guys. It's Eric on for Bose.

Hey Eric.

Hi, good morning. What gives you perhaps more confidence in your ability to manage book value going forward and really would you say that you're managing the portfolio any differently than you were perhaps, say, a year ago, right before the Fed raised rates?

I would say, strategy has been consistent for the last number of years. There's no restructuring or reallocating. It's basically the game plan we laid out. We do probably see more growth in the loan portfolio, but that's because it doesn't turnover as quickly as a three-year step-up portfolio. The other part of question is managing book value. When we buy an asset, we look at the projected future cash flows. And as I said in our preamble, we have staying power. I'm not necessarily disappointed if these assets become cheaper as long as we're not changing our credit assumptions and our cash flow. So, no change in strategy and investment and no changes in strategy in book value. Our book value is up, but we're not crowing about it. What we really care about is the assumptions and the performance of the assets in terms of cash flow and credit. What the market does? It gives us opportunities.

Thanks, Bill. That's helpful. And then how much longer do you expect the RPL/NPL space to stay attractive for it? It seems to me like the lifespan of that market might be a little perhaps long in the tooth, simply given how far beyond the financial crisis we are and maybe there's nothing left that's maybe undiscovered in the market, given how much more stable it is.

So, we've been living with the -- it's too soon or too late question for 18 years. We believe that the opportunity is not billions, it's not $10 billions, it's hundreds of billions to come. I sometimes joke that Craig and I are going to be investing in 2005, 2006 and 2010 vintage assets for the rest of our natural lives. So, we see a very, very large potential supply. I mean, you could do the research, just look at the GSEs, the supply dwarfs our investment needs.

Do you think there could be supply that comes out of the GSEs in a serious scale over the next couple of years?

Yes. Absolutely.

Okay. Last question, if you don't mind. Just any trends that you've seen in the funding markets for non-agency MBS lately and would you say that your funding cost represents a level that's already adjusted to a supposed Fed hike in December?

We've seen more of our counterparties be, if anything, a bit more aggressive in wanting to fund non-agencies. We continue to get requests for new counterparties coming to us that want to lend against those assets. So, we don't see any issues now. If the Fed does raise all these -- the funding that's tied to LIBOR, so if LIBOR goes up, funding costs will go up. We actually have a few billion dollars of swaps as well that will help protect against that. But the funding environment right now is very attractive.

Got you. Thanks guys and well done on a solid quarter.

Thank you, Eric.

Our next question today comes from the line of Jessica Levi-Ribner with FBR. Please go ahead.

Good morning. Thanks for taking my question.

Good morning.

One question, your leverage take down this quarter, I'm guessing because of the non-agency sales, and how do we think about what your target leverage is going forward?

Okay. Actually, again as I mentioned in the preamble, the leverage went down because the assets appreciated and the equity went up more than anything. So, it's a small -- look we don't replace assets run off on a day-by-day basis or month-by-month or quarter-by-quarter. We invested $800 million this quarter. We took advantage of opportunities. The runoff in the RPL/NPL securities, I think, was $500 million. So these are very large. But we do not target leverage. We look at what investments work, as well as we remain comfortable that we can adjust to any changes in equity value, but the change from 3.3 to 3.1 is primarily due to appreciation of our equity base.

Okay. And on the NPL/RPL acquisition side, what kind of competition are you seeing? I know there is a lot of supply. As you've mentioned, as a lot of other market participants have mentioned, but are you seeing the same sort of demand and competition, and how do you think about pricing around that?

We've seen the distinct supply and what we've seen in terms of the buyer base, the buyer base has not changed all that much over the past several years. Maybe, there have been more entrants looking at the re-performing loan side, but it seems as though, on the non-forming loan side, it's been very stable in terms of the amount of buyers, the amount of goods received at an option.

Okay. Thank you very much.

Sure Jessica.

[Operator Instructions] And we'll go to Rick Shane with JPMorgan.

Hey guys. Thank you for taking my question this morning. Very quickly, look, I think the next trend that we're going to see is -- and I think we're starting to see this demographically and I think that the rate environment is probably going to dictate this as well. But a lot of the activity going forward in terms of mortgage originations is likely to be first-time homebuyers. I'm curious how you think about that in terms of your opportunity for credit sensitive assets and where you see the potential growth there?

Thanks for the question, Rick. As I mentioned, our focus remains 2005, 2006, 2007's vintage. So we're not as much a buyer. We'll be originating loans or even new securitizations of these loans. But in terms of first-time buyers, I think you've probably seen trends in payments going down too, Rick, right? As long as the economy grows, as people keep their jobs, it should work. But we're not a large player in new originations, we're not even a player at all really in the originated loans or securities backed by these loans.

And you don't foresee participating in some of the CRT deals that are likely to come related to that over the next few years?

So I would say to date, we've been an opportunistic buyer of smaller pieces of CRTs of older vintage on the days when spreads widened. Yes, we look at -- the structures have changed, the credit enhancement has changed, and as you will point out, the underlying characteristics of the loans have changed. So we have to take that into account. They are somewhat riskier but if the spreads are there, we'll make an investment in the more newer originated CRT backed by younger loans.

Got it. Okay. Thank you.

Thank you for the question Rick.

Our next question comes from the line of Doug Harter with Credit Suisse. Please go ahead.

Hey guys. This is actually Josh on for Doug. Just curious, saw your -- the credit risk transfer investment increased during the quarter, and since those have rallied from the -- what we saw throughout the second quarter and into the third quarter. Curious how you're thinking about the attractiveness of that market going forward? Thanks.

Well, the good news is at September 30, I believe, we had about $350 million of these credit risk transfer securities. As I mentioned, we're an opportunistic buyer. You don't hear us talking about it much on the presentation, because it's not a core part of the portfolio or a large. The good news is by being an opportunistic buyer, we're up about $20 million or nearly six points, and we're comfortable holding this. We don't see a need to sell, but we don't have to be a buyer if the spreads aren't there either. So, it's a very opportunistic strategy. We like the structures, but it all depends on the spread day-to-day.

Got it. Thanks so much.

Thank you.

[Operator Instructions] And nobody else is queuing up at this time.

Okay. I'd like to thank everyone for listening in, and we look forward to speaking to you all next quarter.

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