MFA Financial, Inc. (MFA) Q4 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen thank you for standing by and welcome to the MFA Financial Inc. Fourth Quarter Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session 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 our first speaker, Mr. Harold Schwartz. Please go ahead.

Thank you, operator. Good morning everyone. 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, 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, 2016, 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 fourth quarter 2017 financial results. Thank you for your time. I would now like to turn the call over to MFA's Chief Executive Officer, Craig Knutson.

Thank you, Hal. Good morning everyone. I'd like to welcome you to MFA's fourth quarter and year end 2017 financial results webcast. With me today are Steve Yarad, CFO; Gudmundur Kristjansson, Senior Vice President; Bryan Wulfsohn, Senior Vice President; and other members of senior management. We are pleased with both MFA's financial results and our investment activity in the fourth quarter of 2017. We experienced unprecedented runoff of residential mortgage credit assets during 2017 with total runoff for the year of $4.3 billion dollars. Against the backdrop of continued strong pricing in mortgage and credit assets, it was a challenging year to reinvest our capital at attractive levels. Our investment team worked harder than ever before in 2017 to source and procure assets at price levels that offer good risk return profiles. As difficult as it is to maintain pricing discipline given the circumstances, I'm proud to report that we've been able to source new investments at prices that we believe will produce good returns. As we sit here, only a month and a half into 2018, it seems obvious that we should expect the financial markets to be much less complacent than they were in 2017. With economic growth both domestically and throughout the world, fiscal stimulus related to the recent passage of tax reform and the Federal Reserve that will likely continue both monetary tightening and balance sheet reduction during 2018, the likelihood of the market and pricing disruptions seems inevitable. While we cannot predict precisely where affected investment opportunities will present themselves, we're confident that we will have an early seat at the table. MFA has substantial liquidity, significant additional leverage capacity, and the intellectual capability to allow us to participate and invest in meaningful size in whatever market opportunities arise. Please turn to page three. We generated earnings per share of $0.24 in the fourth quarter and $0.79 per share for the year of 2017. Fourth quarter results were positively impacted by gains on fair value whole loans of $41 million, $15 million of which was actual cash receipts and a recovery of CRT prices after hurricane-related declines in the third quarter. Our book value was unchanged in the fourth quarter at $7.70 per share and up slightly from $7.62 at year end 2016, due primarily to our investment strategy coupled with low levels of leverage. MFA's book value has been very stable with less than a 2% variance between high and low book value for the last year and a quarter-over-quarter average variance of less than 1%. We paid common shareholders a $0.20 dividend for the fourth quarter of 2017, the 17th consecutive quarter in which we have paid a $0.20 dividend. I'm particularly pleased to announce that our new investments kept pace with our runoff in the fourth quarter of 2017. MFA's new investments in the fourth quarter were just over $700 million, including over $550 million in three large credit-sensitive whole loan trades that settled late in December. Primarily because our new investments utilize less leverage than our assets that paid off, particularly agencies, we were able to deploy $160 million of incremental capital in the fourth quarter. And finally, our estimated undistributed taxable income at 2017 year end was $0.15 per share, which is down $0.01 from $0.16 at 2016 year end. Turning to page four. MFA began operations nearly 20 years ago and the company has generated strong and generally consistent long-term returns to investors through volatile markets and through various interest rate and credit cycles. Since January of 2000, we've generated annualized shareholder returns of 15% and shareholder returns over the last one, five and 10-year periods have ranged from approximately 12% to 14%. Turning to page five. In 2017, we focused primarily on credit-sensitive residential mortgage assets. The credit assets we have acquired continued to perform well, tend to be short-term in nature and therefore, have less interest rate sensitivity. Many of our assets were purchased at a discount, so they actually benefit from increases in prepayment rates. Investor expectations of improved economic growth have positively impacted credit-sensitive assets as have continued home price appreciation and repaired borrower credit profiles. While these trends are positive for the assets we own, the resulting higher market pricing makes new investing more challenging by altering risk return profiles. We have maintained our pricing discipline, which means often we don't win bids while continuously reevaluating our existing asset classes as well as exploring new opportunities. As I touched on in my earlier comments, we believe that the likelihood of market uncertainty and potential asset price disruptions is materially higher in 2018 than it was in 2017. Our investment strategy of focusing on shorter term assets with more sensitivity to credit than to interest rates is designed to preserve book value while still producing attractive returns. Because MFA has lower leverage, less interest rate sensitivity and reduced prepayment sensitivity than other similar companies, our returns are achieved with materially less risk. We will look to continue to expand our investment opportunity set within the mortgage residential space, focusing particularly on credit and utilizing the same disciplined approach to risk and reward as we have done historically. Furthermore, our substantial liquidity together with our low level of leverage, provides us with significant dry powder to take advantage of spread widening and/or other market opportunities that arise, whether in credit or rates. Turning to page six. Supply of credit-sensitive residential whole loans is sporadic. That is we can only buy them when they are for sale as opposed to agency MBS, which can be bought or sold every day. Despite a challenging investment environment, we purchased over $700 million of assets in the fourth quarter of 2017. Portfolio runoff again slowed in the fourth quarter and our investment activity slightly exceeded runoff. Because our incremental investment assets utilize less leverage than the assets that ran off, we deployed approximately $160 million more capital during the fourth quarter. And now I'll turn the call over to Steve Yarad, who will provide further details on the financial results for the fourth quarter.

Thanks Craig. As Craig has outlined earlier in his presentation, MFA's financial results for the fourth quarter continued to be highlighted by book value and dividend stability. In addition, our higher earnings this quarter were primarily generated by certain of our assets accounted for at fair value. Please turn to page seven, where we present a summary analysis of the key items impacting net income this quarter. In reviewing our results, you will note an increasing contribution of other income items to overall net income. In the fourth quarter, lower sequential net interest income due primarily to continued runoff and interest earning assets was more than offset by higher net other income, which was driven by the following. One, strong performance from fair value loans, which exhibited mark-to-market gains and increased cash receipts; and two, increases in unrealized gains of CRT securities held at fair value. Unrealized gains for the quarter were approximately $13.5 million compared to unrealized losses in the prior quarter of approximately $5.2 million and turnaround in EPS terms of nearly $0.05 per common share. This reverses the decline that occurred in the third quarter when compared to the second quarter. Income from fair value loans included $21.1 million of net unrealized gains. This is roughly $16 million more than the prior quarter. Further, a significant amount of cash income was also generated, including $10.2 million of coupon and other income, roughly $4 million in the prior quarter. In addition, gains on transfer to REO and cash liquidation gains totaled $6.8 million. This is $3 million than the -- higher than the prior quarter. In addition to higher other income this quarter, net income was also boosted by lower G&A expenses, which were down approximately $5.8 million this quarter with non-recurring expenses related to payment to the estate of our former CEO we recorded in the third quarter. These payments, finalization of the full year incentive compensation accrual, resulted in lower overall compensation expense compared to the third quarter. On a year-to-date basis, G&A expense as a percentage of our equity was stable at approximately 1.5%. As we have noted on our recent earnings calls, the increased contribution of other income to MFA's overall earnings, including some items accounted for at fair value due to our accounting election of the fair value option, may result in fluctuations in the overall level of MFA's net income in future reporting periods. And now I would like to turn the call over to Gudmundur Kristjansson, who'll provide more details about our investment activity and portfolio performance for the quarter.

Thank you, Steve. Turning to page eight, where we show fourth quarter investment flows. In the quarter, we found investment opportunities in most of our targeted asset classes with most activity in whole loans and MSR-related assets. We invested in excess of $700 million in the quarter, slightly in excess of our assets runoff, which declined from elevated levels experienced earlier in the year as RPL/NPL runoff declined to more normal levels. Turning to page nine. As most of us know, the Fed has raised rates five times in the last two years, raising the target range for fed funds from zero to 25 basis points in 2015 to a target range of 125 to 150 basis point currently. Despite this, MFA's net interest rate spread has remained stable at around 2% while the yield and interest earning assets have increased by about 80 basis points to 4.8% in the fourth quarter of 2017. We've been able to achieve this due to continued improvements in the credit performance of our credit-sensitive assets as well as the preference for short duration and floating-rate assets. In addition, our funding rates have risen slower than fed funds as our interest rate swaps have mitigated the impact of higher rates and dealers and banks have become increasingly interested in lending on a secure basis against quality collateral at higher rates, with tighter spreads than before. Turning to page 10. Here, we show the yields, cost of funds and spreads for our more significant holdings. Given the current yields of our assets and the yields we're seeing in the marketplace, we believe that it would be an appropriate amount of leverage for each of our asset classes, we will continue to generate attractive returns for our shareholders. Turning to page 11, where we will review MFA's interest rate sensitivity. Our asset duration increased by 10 basis points to 141 basis point in the fourth quarter, primarily due to deploying more cash into investments as well as a small extension on our agency MBS. The size of our interest rate swap portfolio was unchanged in the quarter at $2.55 billion, while the hedge duration declined approximately 20 basis points to minus 210 basis points as our swaps shortened naturally over time. In addition to market value protection of interest rate swaps currently hedged about one third of our repurchase agreement. As a result, MFA's net duration increased 15 basis points in the quarter to 91 basis point at the end of the fourth quarter. As interstate volatility picks up, it is important to keep in mind that many of our assets are primarily sensitive to mortgage credit and approximately two-thirds of our assets have adjustable-rate coupons step-up structures or are hybrid ARMs. In addition, our legacy non-agency MBS and agency MBS portfolios are highly seasoned, limiting the impact that rising rates has on their duration. The combination of these factors contributes to our portfolio having limited exposure to long-term interest rates and importantly, limiting the extension of our assets when interest rates rise. As a result, we tend to worry little about the extension of our portfolio when interest rates rise. Turning to page 12. MFA strategy of limiting interest rate risk has consistently delivered book value stability, limiting the quarter-over-quarter changes in book value we have experienced. A big factor in achieving this has been our strategy of maintaining a low and stable asset duration as we can see from the orange line on the left graph on this page. In the last few years, the largest quarter-over-quarter change of book value was 4% with the average change being less than 2%. In addition to book value stability, our portfolio continues to exhibit low sensitivity to changes in prepayment rates as the discount accretion in our legacy non-agency MBS portfolio continues to outpace the premium amortization in our agency MBS portfolio and the impact of agency MBS premium amortization on MFA's earnings has diminished over time. This is primarily due to the fact that the 29-point average purchase discount on our legacy non-Agency MBS is much larger than the four-point average purchase premium of our agency MBS portfolio. In addition, strong home price appreciation and better access to credit for legacy non-agency borrowers continues to support prepayments on our legacy non-agency MBS, while seasoning of our agency MBS portfolio and lower loan balance for our 15-year fixed agency MBS continues to limit prepayment volatility on our agency MBS holdings. Due to these factors, we believe MFA's earnings will continue to be relatively insensitive to changes in prepayment rates. With that, I will turn the call over to Bryan Wulfsohn, who will discuss the credit-sensitive assets in more detail.

Thank you, Gudmundur. Turning to page 13. Residential mortgage credit market continues to enjoy both fundamental and technical support. Interest rates and mortgage rates are rising, but still remain low by historical standards. The unemployment rate is down to 4.1%, down from 4.7% a year ago. The number of homes with negative equity continues to fall, estimated at 4.9% in December versus 6.3% a year ago. When people have equity in their homes and are employed, they tend to make their mortgage payments. According to the CoreLogic loan performance insights report released in January, the latest reported month end delinquencies dropped a tenth of a percent to 5.1% versus a year ago. Turning to page 14. We continue to have success acquiring packages of residential whole loans adding over $554 million in the fourth quarter. We lean towards purchasing NPLs over RPLs as we saw RPL spreads tighten. 2017, we saw robust trading volumes of over $40 billion of NPLs and RPLs, which is actually slightly higher than 2016. The majority of this volume was RPLs, which was not the case in 2016. We expect this to continue in 2018 as fewer loans become delinquent and existing NPLs either resolve through re-performance or liquidation. We successfully created and sold $235 million of senior unrated securities backed by mostly NPLs at a three and three-eighths yield in the fourth quarter. We expect to do more if the market conditions remain attractive, which is borrowing on facilities. Returns on nonperforming loans continue to be consistent with our expectation of 5% to 7%. Again, as a reminder, our residential whole loans appear on our balance sheet on two lines; loans held at carrying value, $909 million, and loans held at fair value, $1.325 billion. 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 nonperforming loans. Turning to page 15. We believe our oversight of servicing decisions and active management of the portfolio produces better economic output. This slide shows the outcomes for loan that we purchased prior to December month end 2016, therefore, owned for more than one year. 31% of loans that were delinquent at purchase are now either performing or paid in full. 38% have either liquidated or REO to be liquidated, and 31% are still in non-performing status. We are very pleased with our performance since modification as over 80% of our modifications are either performing or have paid in full. These results continue to outperform our initial expectations for re-performs. Turning to page 16. We continue to lead the RPL/NPL MBS portfolio run down in the fourth quarter. Current market yields for A1s are approximately 3% and three-eighths percent and around 5% for A2s. This asset class has seen strong demand, leading to existing deals getting reissued once callable at lower yields and tighter spreads. Significant appetite from unlevered buyers continues to be the driver for spread tightening. Turning to page 17. After several years of showing the current LTV distribution of the loans underlying our legacy non-agency MBS portfolio, we thought it would be appropriate to show the LTV distribution when this chart was first shown in Q1 of 2014 as compared to the LTV distribution today. The charcoal bars represent the distribution today shows that LTVs less than 80% make up over 84% of our portfolio versus less than 50% back in 2014. The improvement has led to an increased ability to refinance resulting in faster prepaid and lower expected default and severities. 100% of the loans underlying our legacy non-agency portfolio are now amortizing. This principal amortization together with home price appreciation continues to reduce LTV. And now I'd like to turn the call back over to Craig.

Thank you, Bryan. Turning to page 18. In summary, we remain active in the investment market. We have maintained our disciplined pricing approach, which sometimes means we don't win bids. We are investing for the long-term, so we are keenly aware that reaching too much for investments can lock in years of suboptimal returns. Our investment team is working harder than ever to reevaluate various asset classes and diligence new opportunities. We cannot always predict what the next attractive investment opportunity will be, but we are quite confident that we will have a seat at the table, the expertise to understand and structure the transaction, and ample capital to be able to invest in meaningful size. This concludes our prepared remarks. Operator, would you please open up the call for questions?

[Operator Instructions] And our first question today comes from the line of Jessica Levi-Ribner with B. Riley FBR. Please go ahead.

Good morning. Thanks so much for taking my call and a great quarter.

Thanks Jessica.

A question on hedging out your repo now that rates are really rising. How are you thinking about that? Are you going to increase the amount of hedges you have on balance sheet?

Hi Jessica. This is Gudmundur. So, as we see it right now, we feel pretty comfortable with our position. We -- in addition to our currency results we have, which is in excess of one third, it's close to 40% of all our repurchase agreement. We've also benefited over time, as I said, from increased appetite from lenders in general to lend against our collateral. So, as rates have risen, the funding spreads have come down. And so for example, if we were borrowing at LIBOR plus 200 a year ago against legacies, that’s now comes down to LIBOR plus anywhere from 120 to 140. And so that has mitigated the need to add additional swaps to hedge that. So, as we look forward, we think we'll continue to see some benefit up there, but we feel we're in a pretty good position. It doesn't mean that if we feel like the economy continues to heat up, that we might add swaps to mitigate some of those risks. But we feel pretty good about our position.

Jessica, the other thing I would add is we did two securitizations last year as well, which turns out financing on our loans.

Yes, and they were at a fixed rate.

Okay.

And the other thing is as Craig pointed out in his remarks, as the agency MBS portfolio pays down, that tends to have more leverage and more repo utilization. Our swaps at rate remain relatively unchanged. So, over the next year or so as the agency pays down, if you replace that with lower levered assets, our swap hedge ratio will actually increase relative to the repos.

And we do have a question from the line of Bose George with KBW. Please go ahead.

Thanks. I appreciate it. And congrats on a good quarter. I'm hoping that you can just elaborate just a little bit on the pipeline you're seeing out there right now for more whole loan acquisitions. And just if you can comment on the spreads and how the returns overall compare to, I guess, what we're looking at in the press releases as your, I guess, what you're earning on the return in that portfolio now. Thanks.

Sure. So, as I mentioned earlier from a spread perspective, we have seen RPL spreads continue to grind tighter. So, they're not as attractive as they were early, mid last year. So, what has to be, I would say, more heavily focused on the non-performing side. And we have seen supply and we do expect to see significant supply, well probably not as much as 2017, more than enough for us to deploy incremental capital into the space.

And the source of the supply, are those banks? Are they other investment managers? Who are they exactly?

We've seen both, but we also continue to see selling from the GSEs, so -- and that should continue as well.

Yes, great. And switching over to the credit risk transfer space. Can you just give us your breakdown between high LTV and low LTV pools and just the overall attractiveness you see between each of those right now? Thanks.

So, I don't have those exact numbers. We can look to disclose that in the future, but it's probably primarily lower LTV rather than higher LTV.

Yes. Do you guys look closely at a high LTV? I mean, is that something you consider doing eventually?

Yes, of course. Right, of course. I mean, not to say we don't have any. We certainly do. But it's all part of the analysis that goes into deciding whether the risk return is appropriate or not.

Sure of course. All right. Thanks for the comments.

Sure.

And we do have a question from the line of Doug Herter with Credit Suisse. Please go ahead.

Hey guys. This is actually Josh Bolton on for Doug. Given the large amount of prepayments we saw last year, would you say that you're fully deployed today? Or is there more incremental cash on the balance sheet that can be put to work? Thanks.

Sure. So, we have ample liquidity. We did see a lot of pay downs last year. I think if you look at our leverage, it's probably at an all-time low. I think our cash position is probably a little bit less than it was at the end of September. But I think, we think we're -- yes, we have plenty of dry powder. I think this year certainly feels very different from last year and we're not sure where the opportunities will show up, but I think we're well positioned to take advantage of those.

Great. Thanks. And just in terms of year-to-date, we've seen volatility in the equity markets in the fixed income markets. Any update on directionally where book value sits today or at the end of January? Thanks.

Sure. In all honesty, we still don't have the final loan marks for even January yet. But what I would say is that I think as far as the end of January or even extending to today, I don't think there is really very much of a meaningful change in our book value. The legacy, the credit spreads have held in very well so I don't see much significant change in book value. It's down -- it might be down by a couple pennies, but I think it's pretty much unchanged so far for the year.

Great. Thanks for the answers.

You're welcome.

And we do have a question from the line of Steve Delaney with JMP Securities. Please go ahead.

Thanks. Good morning everyone and congrats on the great quarter all around. Craig, under the topic of new opportunities that I think you referenced a couple of times in your remarks, I'm curious if you guys are seeing anything to do with sort of new production NQMs that are out there? We're seeing a little of that going on in a couple of your peers, EFC and RWT and just curious if that's an area where you're looking to get involved. Thanks.

It's certainly an area that we're familiar with. As you know, typically, we don't -- pre-announce investment opportunities, but suffice it to say that I don't think there are any investment opportunities out there that we haven't spent quite a bit of time on.

Okay. Thanks. That's pretty clear. Thanks Craig. And just looking at page 10 on your agency MBS, I knew the spreads -- the net spread was going to be pretty low just given the short duration. I didn't know it will be 29 basis points, so that looks like it's sort of a mid-single-digit ROE. And it's $3 billion of assets, obviously much less than equity. Should we just think of that as you're looking to continue to grow your core strategy of credit-sensitive assets? Is this just a storehouse of cash and something that you can tap into as if you were to see an opportunistic -- opportunity, this be where the capital will come from? Thanks.

Yes, so you accurately described this. So, it's a little less than 10% of our equity is allocated to the agency portfolio. In the grand scheme of our equity disclosure, it's really low. The other thing is the way that we allocate the hedging cost of the swaps, it really just shows up in the agencies in the legacy non-agency MBS. Although we think we will be more holistically as hatch for the entire company. So, if you were to evenly distribute it, you will see different results. Now, it doesn't mean that the agency ROE will certainly go up at 10%. It will still be in single-digits, but it probably would look a little bit better than that page.

Got it.

We think that it is a small equity allocation. Now, given what has happened in the marketplace and where we're seeing in terms of interest rates, where we could deploy capital in the agency space is a lot more attractive than it was two or three years ago, and so we feel pretty happy with our decision not to settle ourselves with long duration assets that are now underwater. And we feel going forward there might be more opportunities there this year.

Yes, and it's -- even though the fed is not -- doesn't in 15 years, I don't believe probably not going to be selling those. But would that be the asset within agency MBS, would it be the 15-year product that you will focus on if those spreads blew out?

Yes. Well, I mean, as Craig has said, everything is on the table, and so we will evaluate everything from hybrids through 30 years. And it really is just figuring out where the best relative value is. The other thing I would say regarding the agency MBS portfolio, because it's so highly seasoned, we're getting a lot of principal back every month just for amortization. And so you would expect this portfolio to pay down anywhere from 20% to 25% throughout the year.

Okay, great. Appreciate the comments. Thank you.

Thanks Steve.

Thanks Steve.

[Operator Instructions] And it does appear at this time, there are no further questions from the phone lines. Please continue.

Okay. Thank you, everyone. Thanks for joining us today. We look forward to speaking to you again next quarter.