Cherry Hill Mortgage Investment Corp (CHMI) 2014 Q3 法說會逐字稿

Greetings and welcome to the Cherry Hill Mortgage third-quarter 2014 earnings conference call.

(Operator Instructions)

I'd now like to turn the conference over to your host, Michael Hutchby. Thank you. You may now begin.

Good afternoon. We would like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's third-quarter 2014 conference call. In addition to this call, we have filed a press release that was distributed today and posted to the Investor Relation section of our website at www.chmireit.com.

On today's call, Management's prepared remarks and answers to your questions may contain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ from those discussed today. Examples of forward-looking statements include those related to interest income, financial guidance, IRR, future expected cash flows as well as prepayment and recapture rates, delinquencies, and non-GAAP financial measures, such as comprehensive income.

Forward-looking statements represent Management's current estimates and Cherry Hill assumes no obligation to update any forward-looking statements in the future. We encourage listeners to review the more detailed discussions related to these forward-looking statements contained in the Company's filings with the SEC, and the definition that's contained in the financial presentations available on the Company's website.

Today's conference call is hosted by Jay Lown, our President and Chief Investment Officer. Also present on the call today are Marty Levine, our Chief Financial Officer; and Julian Evans, our Senior Portfolio Manager. And now, I will turn the call over to Jay.

Thanks, Mike, and thank you, everyone, for joining us today on our third-quarter 2014 earnings conference call. As part of the call, we've posted on our website presentations that we will touch upon throughout the call and we'll reference specific slides where appropriate. After our prepared remarks, we will open up the call for your questions.

It's safe to say that a year ago when we launched Cherry Hill there was a stronger view that interest rates were headed higher and arguably considerably higher. Despite a year of significant volatility, rates were substantially unchanged year over year. In fact, the US 10-year Treasury closed 12 basis points lower on September 30 this year versus a year ago.

The domestic economic recovery is on firmer footing. The US growth has been moderate but clearly improving. Global macroeconomic challenges, however, persist. Global interest rates remain range-bound and choppy, as skittish markets await more data in the near term. Long-term, our investment thesis remains prejudiced towards rising rates and our portfolio is well-positioned for this.

Specific to Cherry Hill, the third quarter produced results substantially in line with the second quarter. To this end, our mission remains unchanged: to generate consistent, attractive returns for our shareholders. We believe our current portfolio as constructed does just that and we are committed to broadening the scope of investment opportunities as we look for ways to grow our Business.

Notable market takeaways for the quarter include a continued downward trend in rates, increased market volatility, and increased gross prepayment speeds. As shown on Slide 5, MBS prepayment speeds have consistently increased quarter over quarter throughout the year, as interest rates have fallen. Accordingly, a primary focus for our team is the run-off of our portfolio, and we are working with Freedom to protect and defend our investments.

We remain focused on the MSR asset class to execute our investment strategy, and believe it offers attractive returns over the long term, especially in a higher interest rate environment. During recent months, however, Excess MSRs were deemed to be less attractive given current market pricing. As such, we deployed excess capital into agency RMBS over the quarter. As we have previously stated, having the ability to purchase full MSRs should broaden our investment option and we believe that there will be a healthy supply of full MSRs in the near term.

Turning to our quarterly results as shown on slide 6, the third quarter produced dividend-eligible income consistent with the second quarter. We declared and subsequently distributed a $0.51 dividend to our shareholders. Net interest spread for the RMBS portfolio for the quarter, 1.55%, marginally lower than the 1.59% in the first half of the year, and prepaid speeds for the RMBS portfolio averaged slightly over 5% CPR, in line with Management's expectations.

Throughout the year, our RMBS portfolio has exhibited favorable prepayment characteristics versus generic and TBA cohorts. Book value per share this quarter dropped slightly to $21.22, primarily as a result of a reduction in value of our investment in Excess MSRs, driven by an increase in prepayment expectations. In addition, RMBS has had a difficult time keeping pace with the interest rates as rates rally.

Our aggregate debt-to-equity ratio at quarter end was approximately 2.1 times, up slightly from the second quarter but not unexpected given our reinvestment of principal and agency RMBS. During the third quarter, we made significant progress in our efforts to license our taxable REIT subsidiary to be able to purchase full MSRs and whole loans. Currently, we are licensed in 15 of the 17 states required for us to own MSRs and to purchase closed residential whole loans on a nationwide basis. Approvals from the GSEs and Ginnie, serviced mortgages are more time-consuming to acquire and we hope to have them in place by the end of the first quarter of 2015.

During previous calls, we have also stated we are taking a two-pronged approach here and are actively searching for acquisition targets that fit our needs in addition to our organic efforts. We have been looking at originator servicers that could provide us with the necessary approvals and servicing assets that fit our needs. As you can imagine, the mortgage origination community is consolidating and we expect this trend to persist in the near term.

We are committed to executing our whole loan strategy and believe our relationship with Freedom will provide us with significant access to loans once the platform is in place. A diversified business model is integral to our growth and we are focused on investment opportunities in the whole loan space that we think generate good risk-adjusted return: prime jumbo loans, non-QM loans, and [second] loans remain a focus for us. A healthy securitization market is essential for the growth and success of these initiatives.

Let's move on to discuss our investment portfolio. Slide 7 highlights our aggregate portfolio composition. At quarter-end, our Excess MSR investment represented approximately 62% of our equity capital and approximately 20% of our assets, excluding cash. Our RMBS portfolio comprised approximately 33% of equity and approximately 80% of assets, again excluding cash. The RMBS portfolio remains concentrated in shorter-duration assets. We did, however, increase our exposure to longer-duration assets in light of the current interest rate environment, and Julian will discuss the performance of this portfolio in more detail shortly. At the aggregate portfolio level, we maintained a neutral duration gap throughout the quarter, and at quarter end, our duration gap stood at negative 0.09 years.

Our Excess MSR portfolio for the third quarter, which is referenced on slides 8 and 9, performed in line with Management expectations, generating solid returns during the quarter. The current carrying value of this portfolio stood at approximately $96 million at quarter end. Our recapture agreement resulted in over $670 million in loans being recaptured during the quarter. The vast majority in Pool 2 was posted at a 53% recapture rate.

[Light] to-date, Freedom recaptured over $1.8 billion in loans for our portfolio. Freedom has done an outstanding job protecting and defending our portfolio and we actively work together to seek ways to improve these results. Weighted average CPRs, net of recapture, for all of our Excess MSR portfolios remain within current Management expectations. In light of declining interest rates year to date, we did experience a decline in the value of Pool 1, primarily driven by an expectation of higher prepayment speeds.

I'll now turn the presentation over to Julian, who will provide some detailed information on the agency RMBS portfolio and its performance over the quarter.

Thank you, Jay.

As of September 30, the RMBS portfolio stood at $376 million, up from $343 million at the end of the second quarter, as shown on slide 10. The portfolio remains concentrated in shorter-duration assets and was run on modest leverage, at 6.29 times. At quarter end, approximately 54% of assets were comprised of 20-year and 15-year fixed rate [whole] pools; and the remainder, in 30-year fixed rate whole pools, TBAs and hybrid ARMs.

During the quarter, additional RMBS purchases were made in the 30-year and 20-year collateral at the expense of 15-year collateral. As shown on Slide 11, loan balance stories remain a majority of the overall collateral composition at quarter end. The portfolio's composition continued to exhibit favorable prepayment speeds due to its composition, posting a weighted average 5.03% CPR for the quarter and 5% CPR for the last six months. Going forward, we would expect prepayment speeds to increase, given the portfolio's composition and the persistent drop in mortgage rates that occurred during the third and the beginning of the fourth quarter.

The aggregate portfolio continues to be managed conservatively. The portfolio operated with modest leverage and a fairly neutral duration gap given our long-term interest rate views and current fundamental mortgage valuation. As shown on slide 12, we ended the quarter with an aggregate portfolio duration gap of a negative 0.09 years. The portfolio's duration gap remains stable under various interest rate stress scenarios.

Our duration gap would move from a negative 0.09 years to a positive 0.04 years following a 200-basis point instantaneous shock according to our model. The portfolio's gap is driven by the composition of RMBS portfolio, the associated hedges, and the fact that over 60% of the portfolio's equity was comprised of Excess MSRs during the third quarter.

I will now turn the call over to Marty Levine who will review our third-quarter financial results in more detail. Marty?

Thank you, Julian.

As Jay stated in his opening remarks, we had another solid quarter. Net interest income was approximately $5.1 million in the third quarter; however, our Excess MSRs, RMBS, swaps, and swaptions reduced the combined net decrease in asset value of approximately $3 million. Our GAAP net income for the quarter was $2.8 million, or $0.37 per share. Our comprehensive income, which includes the mark-to-market on our held-for-sale RMBS, was $844,000 or $0.11 per share.

As detailed in slide 25, we use interest rate swaps and interest rate swaptions 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 swaps and swaptions, which allow us to enter into rate swaps at a later date, with notional values of approximately $210 million and approximately $115 million, respectively. For GAAP purposes, we have not elected to apply hedge accounting for our interest rate derivatives, and as a result, we record the change in estimated fair value as a component of the net gain or loss on interest rate derivatives.

Also, as Jay mentioned earlier, 62% of our equity capital is deployed in Excess MSRs at quarter end. Our investment in Excess MSRs are currently unlevered, and our implied debt-to-equity ratio on the RMBS portfolio was leveraged 6.29 times at quarter end. Our overall debt-to-equity ratio was 2.06 times at quarter end.

Operating expenses were $1.3 million for the quarter, which included approximately $115,000, which was related to the licensing efforts and other infrastructure costs relating to CHMI Solutions, our taxable REIT subsidiary. For the quarter, our total operating expense as a percentage of average equity was 3.1%. For the third quarter, we had REIT income eligible for dividend purposes of approximately $3.9 million, which represents $0.52 per share for the quarter.

On September 11, we declared our third-quarter 2014 dividend of $0.51 per share, which was paid on October 28. It is our goal to distribute regular quarterly dividends of all, or substantially all, of our taxable income to holders of our common stock, and to the extent authorized by our Board of Directors.

Lastly, this afternoon we filed two registration statements on Form S-3. The first covers the possible resale of shares held by Stan Middleman. This shelf was filed pursuant to the requirements of the registration rights agreement we entered into with Stan at the time of our IPO and concurrent private placement. We also filed a shelf registration statement for primary issuances by Cherry Hill. Although we have no current plans for an offering, we are being prudent in preparing for the future, should conditions warrant.

Now I'd like to turn the call back to Jay for closing remarks.

Thanks, Marty.

Our primary goal has been and continues to be aimed at delivering consistent attractive returns for shareholders. We're excited about the initiatives underway at Cherry Hill and are looking forward to expanding our strategies and diversifying our business to exploit additional opportunities in the residential mortgage space as the industry evolves.

We'll now open up the call for questions. Operator?

(Operator Instructions)

Our first question comes from Paul Miller from FBR.

Yes, on the prepayment speeds, we saw the volatility in rates really move around over the last couple of weeks. Has that impacted at all your IRR on some of the MSR pulls that you prefaced?

Hey, Paul. How are you? It hasn't affected the IRR as much, no. It has not, no. Our IRRs are essentially similar to what they were in the prior quarter.

So the volatility hasn't had any meaningful impact on those things?

No. We see the increase in speeds on the origination side, here, in terms of the true Excess MSR valuation related to the discount rate. We haven't had significant changes to that.

And then the other thing is your primary seller of assets is Freedom Mortgage. Are you actively seeking out other relationships?

Yes, we are. On a regular basis, we seek other relationships around anything related to both whole loans and MSRs. I will tell you that this year has been an interesting year in the origination space, just based on margins compressing and consolidation amongst originators, small and mid-size. Their primary goal has been to show a profit.

So far throughout this year, we've seen more of a trend in selling the full MSR versus being interested selling in an Excess MSR and treating that as some kind of financing. What I will tell you, that we've seen an increase in margins in the origination space over the last quarter or so. So that could change but, as you know, things are fluid and for the first nine months that's been the trend.

And then you guys, correct me if I'm wrong, you guys don't have a flow agreement with Freedom, right? Or do you and are you seeking out flow agreements with other entities?

We do have the ability to enter into flow agreements with Freedom. Again, that's obviously dependent upon things like price. This quarter, we did not have a flow agreement with Freedom, unlike other previous quarters.

We do look to other counter-parties, as well as Freedom, to do something flow-related. But again, it goes back to the Excess MSR conversation on a broader, more macro basis.

Perfect. Hey guys, thank you very much.

Sure.

Our next question comes from Henry Coffey from Sterne, Agee.

Good afternoon, everyone.

Hey, Henry.

I'm looking at page 6. Can you walk us through the details, preferably on a per share basis, of how we get from $0.37 to $0.52? It shows up -- I know our modeling gets us right there, but I wanted to see what the components were of that figure?

Okay. You take out all the gains and losses as far as the capital transactions, so you have the $5 million worth of interest income and you have about a $1.264 million in expenses. And out of those expenses, about $200,000 of it is not tax deductible, and then there's the about (inaudible) $100,000 and change that is related to the TRS, which is also not tax deductible, and divided it by the number of shares.

I'm looking at your P&L of the $1 million of -- hang on a second I'm sorry?

Sorry I was--

Yes the $1 million loss on derivative position is not part of the equation because -- of the taxable equation because--?

It's a tax hedge and therefore we don't take any of that gain or loss.

Okay.

That's purpose. And we don't take the loss on the Excess MSR, either.

Right, right, right, but because it's a hedge position, it's not included in the taxable equation?

Correct.

The importance of getting a servicer license, this is the first time you've actually been fairly concrete about saying how -- well, reasonably concrete about when you might get something. We talk about what steps remain, how much time remains between now and when you're likely to get a license and what it means to the Company?

Absolutely, sure Henry. So, yes, we were a little bit more descriptive this time. We were required to go after 17 states to be able to purchase the loans and service on a nationwide basis. As we noted on the call, we have 15 of those; we expect the other -- shortly.

The agency approvals, they are a little bit more time consuming. We were looking to get the approvals from both Fannie, Freddie, and Ginnie, and we will be working over the next several months to be able to do that. As we also mentioned, we are looking at inorganic opportunities that will allow us to take a short cut there. But it is our desire and goal to have the licenses and approvals in place to be able to start buying full MSRs in the second quarter.

Why that's important to us is because it's our belief that there are a lot more opportunities around being able to purchase the full MSR versus the ability to purchase the Excess MSR. We continue to see a healthy market in the full MSR space versus the Excess MSR space, so we believe we'll have more opportunities to transact with the servicing license in place.

And what's the difference in the [slash] bid and ask, whether it's between you and Freedom, or you and other parties, in terms of actually putting more assets on now?

That's a tough question to answer on the call. That's a very difficult question for us to answer there, but it's not a small difference. From our perspective, there's a disconnect between what's happening in interest rates and where MSRs are being bid with respect to lifetime CPRs. As such, that disconnect has resulted in us not being as competitive as Freedom might look for us to be, transacting with them today.

Two of the companies -- mortgage REITs we work with have talked recently about steps they have taken or that they can take to ease the whole loan burden -- in other words, the fact that you have to hold a certain amount of agencies to pass the REIT test. Do you have any thoughts on that? And when you think of allocating capital and balances between agencies and servicing, as more opportunities open up, is the agency portfolio a potential source of funds in capital for buying servicing or does it have to stay at its current level?

I would say that we spend a lot of time thinking about what each asset class represents related to passing all of the tests around our Company. We have done a fair amount of work on our side about trying to decide how much capital to allocate to each strategy, as we look to move forward with some of the things in the whole loan space.

So on our side, we have a good grip with respect to what we think we could allocate capital-wise towards loans versus having to continue to allocate a portion of our capital, equity capital, to the agency RMBS strategy. Because of leverage, obviously, you can imagine, given their assets pass the agency RMBS, portfolio is important to passing the test. But we do feel we have the ability to add a healthy percentage of our equity capital to whole loans in some way, shape, or form, either through straight whole loans, or through holding the bottom part of the capital structure in a securitization.

Great, thank you.

Thank you. Our next question comes from Jeremy Campbell from Barclays.

Hey, thanks, guys. Just want to clarify. If you guys look to buy an originator, would that purely be just to set of the GSE licensing or would you potentially look to have the originator actually start producing mortgages for you guys?

That's a great question. We, in a perfect world, you obviously just get licenses, but in the real world that comes with an originator, as origination capacities. And you have to make the decision as to whether or not that company is operating profitably or not. So in an ideal scenario, we are looking for a company that is origination-light, with respect to having all of the licenses and approvals that we would want to have on our end.

So we would look to somebody that is not originating a significant amount of money on a monthly -- or a significant amount of mortgages on a monthly basis. We think we could potentially discuss some of that with Freedom around the origination piece of this. But in a perfect world, I would tell you that it would be our desire to have something that was more holistically around the licenses.

Okay. And then we've seen other companies be able to lever full MSR at least, one-half a turn. Is there anything out there right now for Excess MSRs or is this all predicated on you getting fully licensed and actually owning the full MSRs?

I don't think we're ready to have that conversation, but we do talk to people about the ability to leverage the Excess MSR portfolio in some fashion. Clearly, it's not a wide market, but we definitely are having conversations with people about how to do something in that format.

Then could you just remind us what the addressable market is of assets that you guys may look to target that's on Freedom's balance sheet right now? And maybe update us on what their quarterly production is looking like too?

I'm sorry. I didn't totally get the first part of that question?

How many MSRs will we have on the balance sheet right now that would fit your criteria?

Their overall portfolio is hovering around $50 billion. The vast majority of that is originated over the last three years.

What portion of that would be of interest to us? Well we own $20 billion of it already, so yes, I would say somewhere in the neighborhood of $10 billion to $15 billion could be of interest to us on a holistic basis around the full MSR.

Freedom has recently made a decision to service in-house and has been putting new origination MSRs on their internal servicer, so we look forward to working with them as they grow that platform. Around Freedom's current origination production, I believe Freedom did $2.4 billion last month and in the last three months prior to that, it was somewhere in the neighborhood of $2.2 billion, $2.3 billion, so we are consistently running in the low $2 billions. They've recently closed on an acquisition of a retail originator that was made public a week or so ago and that adds about $100 million to $150 million of retail production, that the Company will start to see the fruits of this month.

Great. Thanks a lot, guys.

Thank you. Our next question comes from Michael Kaye from Citi.

Hi. Could you comment a little bit more on the pricing environment for the whole MSR purposes? Just wondering what kind of IRRs do you think you can get and do you think these returns will allow you to hit a 10% ROE hurdle?

That points back to Jeremy's question, in terms of leverage. On an unlevered basis, I would tell you that we think that MSRs backed by Fannie and Freddie are still in the high single-digits. Not much has traded recently around Ginnie.

There was a large transaction by [Alkaline] recently that never happened. But those portfolios seem to still be trading in the low teens. With leverage available to us on the GSE MSRs, we feel pretty good that the returns would be substantially similar to where we quoted you guys last time, to be in the low teens.

Great and one quick numbers question for Marty. Just wondering why the Management fee went down quarter-over-quarter?

Embarrassingly, we had a misinterpretation of a contract term. It was noted and corrected this quarter. About $150,000 pertained to previous quarters and we speak to it further in the MD&A. On an adjusted basis, comparatively, we would be at $670,000 for the third quarter and $629,000 for the second quarter.

So should I think about $670,000 as the run rate going forward?

Yes.

Okay, thank you.

Thank you. We do have a follow-up coming from the line of Henry Coffey from Sterne, Agee.

You didn't get enough, Henry (laughter)?

Yes, on the -- with the two filings that are out there, is your second filing the shelf equity only or does it look at equity, debt, the full range of the capital spectrum?

Everything. The whole range.

So it's a conventional, filing it in case you need it, but no specific plans to rush out and issue equity below book value?

That's correct. If you look at the filing, it refers to common preferred warrants [right unit], so it is holistic, Henry.

And then, obviously, nobody can speak for Stan, but has he indicated as part of this filing and registration of his shares, that there might be a future sale of the shares or is he going to continue to hold where he is?

To my knowledge, he has not mentioned anything to that extent.

Great, thank you.

Thank you. I will now turn the call back over to Jay Lown for our closing comments.

Great, thank you, everybody. We've (inaudible) business. We look forward to having another successful quarter in the fourth quarter.

Thank you for joining us on our call today. We look forward to updating you guys next quarter on the progress on subsequent calls. Have a great evening.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.