Cherry Hill Mortgage Investment Corp (CHMI) 2016 Q4 法說會逐字稿

Greetings and welcome to the Cherry Hill Mortgage Investment Corporation fourth-quarter and full-year 2016 earnings call.

(Operator Instructions)

As reminder this conference is being recorded.

I would now like to turn the conference over to your host, Mr. Michael Hutchby. Thank you, sir, you may begin.

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's fourth-quarter 2016 conference call. In addition to this call, we have filed a press release that was distributed earlier this afternoon and posted to the investor relations 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, IRRs, future expected cash flows as well as prepayment and recapture rates, delinquencies, and non-GAAP financial measures such as core and comprehensive income.

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

Today's conference call is hosted by Jay Lown, President of Cherry Hill. Also present on the call today are Julian Evans, our Chief Investment Officer; and Marty Levine, our Chief Financial Officer.

Now I will turn the call over to Jay.

Thanks, Mike, and thanks, everyone, for joining us on today's call. It's quite possible that the markets had a major inflection point in the fourth quarter on several levels. From a macro perspective, the election shocked the markets as investors began to expect potential deregulation and tax reform for 2017. Following the election, rates spiked considerably in anticipation of President Trump's proposals, as well as expected Fed tightening which ultimately occurred in December.

From a company standpoint, the quarter was probably the most transformative quarter we've had since going public more than three years ago. In mid-November we announced the sale of our excess MSR portfolio back to Freedom Mortgage. Freedom had come to us with a compelling offer and after careful consideration which included evaluating the illiquidity of the asset, we took advantage of this unique opportunity and accepted the offer.

The sale is highly constructive for the company. We immediately increased our book value, we gained additional flexibility in our portfolio, and we generated significant proceeds to further pursue our full MSR strategy. And as part of the agreement we are also receiving monthly yield maintenance payments of $250,000 from December 2016 through November 2017. At the same time, we eliminated the company's exposures to the $60 billion-plus Ginnie Mae MSR portfolio, Freedom, as the acknowledgement agreement among us, Freedom and Ginnie Mae was terminated in connection with the sale of excess MSRs.

The transformation of Cherry Hill continued into the first quarter of this year. Last month we completed the final portion of the sale by exchanging the remaining excess MSRs we held for full MSRs on loans backing securities guaranteed by Ginnie Mae. This is the conclusion of an 18-month process working with Ginnie Mae to secure approval to service full MSRs, and we believe the sale of the excess MSRs to Freedom certainly helped pave the way. With the Ginnie Mae approval, our taxable REIT subsidiary, Aurora, is now authorized to service loans for all three agencies.

The acquisition of the MSRs roughly doubled the size of our servicing portfolio, and resulted in Aurora ranking in the top 70 of mortgage servicers in America. In all, the sale of the excess MSRs generated a gain on sale of approximately $15 million, $6.6 million of which was recognized in the fourth quarter, and after adjustments resulting in a $1.5 million realized gain on the sale of Pool 1 and Pool 2014. The remainder of the gain will be recognized in the first quarter, as the exchange portion of the sale was completed in February. We further note that in accordance with GAAP, the total gain on sale includes $3 million of yield maintenance payments, effectively converting the payments originally intended to be part of the company's earnings into a portion of Cherry Hill's book value.

Overall for the fourth quarter, we recorded core earnings of $0.51 while generating dividend eligible income of $0.56. Starting this quarter we revised the method for calculating amortization for the purpose of reporting core earnings in order to align ourselves with peers that also have substantial MSR investments. The amortization calculation refers to the portion of the change in fair value of MSRs that is primarily attributable to the realization of cash flows from the run off of the portfolio but that cash flow doesn't come from all loans equally. Previously we treated each underlying loan as if it had the same value, despite the fact that we, just like our peers, actually assign different values to the purchased MSRs, based on the characteristics of those underlying loans.

The footnote on slide 23 shows what core earnings would have been for 2016 had this refined approach been used for the previous three quarters of 2016. Although this method of calculating amortization may alter the amount of amortization used to calculate core earnings in the future, we believe this is a more appropriate accounting method, and is consistent with the accounting utilized by our peers that also own substantial MSR portfolios.

If we look back at the company over the year, we see a pattern of steady dividends, protection of the company's book value, and growth. We took our servicing portfolio from $2 billion to $3.3 billion, and secured MSR financing for the Fannie Mae MSR portfolio. The year began with the stock trading at $13 a share, and ended with the stock trading at $18.19 a share. And the company paid $2.11 in dividends per share to investors over the year, which includes the special dividend announced in December.

In the span of the past four months, we've increased our portfolio's flexibility, raised our book value, received Ginnie Mae approval, doubled the size of our servicing portfolio, and have cash invested in liquid assets that can be deployed quickly into new full MSRs. The strategy that existed at the time of the IPO has now transitioned into a more nimble, operationally centric one that's better positioned to succeed in a fluctuating interest rate environment.

With that, I'll turn the call over to Julian who will cover some of the more detailed highlights of our investment portfolio and its performance over the quarter.

Thank you, Jay. As Jay noted, Trump's presidential election victory had a positive impact on markets as investors and consumers showed renewed optimism with respect to the US economy and investments. Interest rates climbed immediately after the election, with the anticipation of potential inflationary fiscal policies from Washington.

These potential policies and the following rise in interest rates provided the Fed with the necessary cover to raise interest rates at the Fed's December meeting. As December ended, the 10 Year closed the year at 245 basis points, up 85 basis points from September 30 close. We, as well as other investors, are watching the Fed closely, as they've expressed their desire to raise rates three times in 2017, one of which is expected tomorrow.

Moving forward, slide 7 highlights our aggregate investment portfolio composition. At quarter end, our servicing related investments, which include MSRs and Pool 2 Excess MSRs, represented approximately 29% of our equity capital and approximately 8% of our investable assets excluding cash. Servicing related assets as a percentage of total assets declined, due to the completed sale of the Pool 1 and Pool 2014 Excess MSRs during the quarter, and the subsequent temporary deployment of the cash proceeds into the RMBS portfolio. As a result, our RMBS portfolio accounted for approximately 65% of our equity and approximately 91% of our investable assets excluding cash at quarter end.

As shown on slide 8 through 10, the current carrying value of our servicing related assets stood at approximately $61 million at quarter end, as only Pool 2 remain from the Excess MSR portfolio at the end of the year. With rates climbing in the latter part of the quarter, our Net CPR showed improvement, with Pool 2 Net CPR coming in at 14%. For the quarter, Net CPR for our full MSRs averaged 15%, but posted at 12.5% Net CPR in December. Approximately $478 million of loans were recaptured during the quarter on Pool 2, resulting in 71% recapture rate. At quarter end our full MSR investment stood at approximately $32 million.

As of December 31, the RMBS portfolio grew to approximately $666 million, as shown on slide 11, an increase from $533 million as of September 30. The increase was driven by the temporary deployment of proceeds from the sale of the Excess MSR as mentioned above. During the quarter, the RMBS portfolio's composition changed, as we increased our 30 Year securities position to 67% of the portfolio, versus 61% at September 30. 20 Year and 15 Year collateral, as well as shorter duration assets, represented 33% of the RMBS portfolio at quarter end.

In the fourth quarter, the RMBS portfolio posted a weighted average three month CPR of approximately 7.7%, an improvement from 8.8% posted in the previous quarter as shown on slide 12. During the fourth quarter, we moved the portfolio into lower price premium securities, as most markets were repositioning for higher interest rates. As interest rates sold off, the price premiums paid for specified pools weakened, and we would expect this story to continue in 2017 as interest rates march north.

In the first quarter of 2017, price premiums recovered as rates initially firmed up and moved lower, only to reverse as the FOMC and investor sentiment shifted towards an improved inflationary economy, coupled by higher interest and mortgage rates.

Loan balance collateral remained a primary focus of the portfolio. Due to the price premium decline for specified pools, we were able to purchase [story] collateral at attractive levels in the fourth-quarter of 2016 and the first-quarter of 2017, as excess MSR sale proceeds were put to work.

For the fourth quarter, we posted a 1.49% RMBS NIM, net of our Freedom repo transactions, versus a 1.32% NIM for the third quarter. The NIM improvement was driven by repositioning of the RMBS portfolio into 30 Year collateral, specifically higher coupon mortgages and the portfolio maintaining consistent prepays.

Similar to other REITs, we experienced higher repo costs in the fourth quarter. Repo costs averaged 93 basis points, versus averaging 78 basis points in the third quarter. The increased costs were partially offset by increased three month LIBOR, which affected the receiving portion of our swap hedges. Going forward, we would expect our NIM to fluctuate based on higher repo costs.

During the quarter, the aggregate portfolio operated with leverage of 3.96 times, and a negative duration gap. As shown on slide 13, we ended the quarter with an aggregate portfolio duration gap of minus 0.96 years. The lengthening of the duration gap from the previous quarter was driven by the sale of Pool 1 excess MSR and Pool 2014, and the subsequent redeployment of the cash proceeds into mortgages, coupled with high rising interest rates.

I'll now turn the call over to Marty for our fourth-quarter financial discussion.

Thank you, Julian. Our GAAP net income [after call] to common stockholders for the fourth quarter was $26.2 million or $3.48 per share. And our comprehensive income attributable to common stockholders which includes the mark to mark of our held for sale RMBS was $8.1 million or $1.08 per share. Our core earnings as detailed on slide 23 was $3.9 million or $0.51 per share, and we recorded dividend eligible income of $0.56 per share.

The total gain on sale of the Excess MSRs to Freedom was approximately $15 million. During the fourth quarter we recognized approximately $6.6 million of the gain which after adjusting for previous unrealized losses on Pool 1 and Pool 2014 of approximately $2.6 million, and an adjustment to interest income from the retrospective method of approximately $2.4 million, it resulted in a fourth-quarter GAAP net realized gain of $1.5 million on the income statement.

As required by GAAP, the $250,000 monthly yield maintenance payments to be received from December 2016 to November 2017 are included in the GAAP gain on sale total of $15 million, effectively converting those payments into book value rather than GAAP income. For tax purposes, however, the yield maintenance payments are treated as taxable income as received, thereby increasing dividend eligible income. Because those payments are intended to partially mitigate the effects of the sale of the Excess MSRs, we are including those payments in the calculation of core earnings.

As we've consistently noted, we expect there will continue to be a slight difference between core earnings and dividend eligible income, due to ongoing portfolio acquisition expenses. That said, we believe our current quarterly dividend level will remain sustainable in the near future.

As detailed in slide 26, we used a variety of derivative instruments to mitigate the effects of increases in interest rates on a portion of our future repurchase borrowings. At the end of the fourth quarter, we held interest rate swaps, swaptions, TBAs, and treasury futures, and options on treasury futures with a combined notional amount of $549.9 million. 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 the component of the net gain or loss on interest rate derivatives.

Operating expenses were $1.6 million for the quarter, of which approximately $167,000 was related to our taxable REIT subsidiary. For the quarter, our total operating expense as a percentage of average equity was 4%.

On December 8, 2016 we declared dividend of $0.49 per share for the fourth quarter of the year, as well as a $0.15 special dividend, both of which were paid on January 31, 2017. Our goal remains 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.

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

Thanks Marty. At this time we'll open up the call for questions. Operator?

(Operator Instructions)

Steve DeLaney, JMP Securities.

Thank you. Congratulations, guys, on growing your book value year over year. I don't think we have many mortgage REITs that have accomplished that this year -- last year, so congrats. I have to admit I got a little confused on the gain on the excess MSRs starting with the November 15 press release, and Marty, your comments were helpful.

Let me just ask, I want to make sure I get this right. So originally the $16 million gain, it turned out to be $15 million, and now as I hear the comments on how we go from that figure to the GAAP recorded figure in the fourth quarter, did you intend in the November press release to basically describe what your gain was versus your cost basis in those excess MSRs, as opposed to what maybe the net accounting, GAAP accounting gain might be? Can you help me understand that original $16 million or $15 million figure? Thanks.

Hello. The gain was basically off of the 9/30/2016, the last valuation that we had or that you had in front of you. So this was going to be the change basically in total from the excess MSRs. The last time that you saw it, the basis that it was, we were getting $15 million more.

Got it. And the two items you mentioned against the $6.6 million, one I take it, the $2.6 million was just essentially a reversal of some unrealized gain that you had previously booked, is that correct?

Unrealized losses which brought the basis down.

Okay, got it. Unrealized losses had lowered the basis. I got it, I got that.

So once you go back to 12/31 at a higher valuation than I did at 9/30.

Okay. Can you say at this point approximately -- can you give us an estimate for what the net accounting gain might be on Pool 2 that settled in February?

(Laughter) Economically? (Multiple speakers) It's a world unto itself.

I'll withdraw the question. It's probably an unfair question. I'm just trying to make an adjustment to book value. That's all where I was going.

Let me switch gears a little bit to what's going to happen tomorrow with the Fed likely to tighten and who knows if we get one or two more, whatever we get this year, but Julian, in your comments you mentioned potential fluctuation of the spread, of the NIM. It looks like notional -- you've got a swap to RMBS ratio about 62% notional.

When you think about hedging book value, you've got a lot of negative duration in some of your MSRs, but when you think about just cost of funds, and hedging cost of funds and your spread, how do you feel about your swap book, and is it likely if the Fed becomes aggressive that we would see that swap ratio to RMBS increase going forward? Thanks.

Thanks, Steve. Obviously it's a very important thing that we think about is obviously our funding and the costs surrounding that. We have nimbled and increased our hedge ratio to swap throughout the year. I think there's a couple things that we have to think about, not just the swaps but we also have the swaptions and we also have the MSRs as our hedge to the RMBS portfolio when they're fully operating. I'd say yes, our repo costs have risen, and one of the things that has offset that has clearly been the fact that three months LIBOR has risen over the last two years, frankly, as the Fed has started to raise rates.

In addition, I would say throughout 2016 but mainly and probably the last couple of quarters, one of the things that we did in terms of our swap book is we took the opportunity, as rates went lower, we swapped out of our higher interest rate swaps and moved them into lower interest rates. So for example we would match book, if something was a seven year, we'd lower the cost to a seven year, or we'd even extend it out to a 10 year. So if you look at the third-quarter presentation versus the fourth-quarter presentation, one of the things that you will notice is the actual fixed rate on swaps went from 1.43 to 1.46, but the average life on our swap book went from let's say 3.5 to basically 4.7.

Right.

So we have been extending the maturities of our swaps. So the percentage of your hedge ratio is important, but also where you're laying in some of these swaps on the curve is also important to us. So, look we are expecting the Fed to go tomorrow, if we can get through some volatility that may be coming from Europe as well as additional Trump type of policies, I would expect them to go again to raise rates. That may be June, that could be September, but we are planning for that.

In addition, I would say that the shape of the yield curve will be important here. If they do raise rates, does the tenure actually rise, and is it more of a bearish flattener? We do have a good portion of our swaps around the five year and three-year portion of the curve. So there's a lot of circumstances that could arise from simply the Fed just, one, what they have to -- if they raise rates, two, what the verbiage is that she delivers, and three, what the dot plot looks like.

Right.

Steve, this is Jay. The only thing I will add is that as we noted, we're looking to grow the MSR portfolio, so the portfolio is going to be fluid. And so as we look to add more negative duration assets, I think it would be very hard for Julian to pinpoint exactly where he feels comfortable or we feel comfortable on the absolute hedge ratio given the types of sourcing mix that we might add over the year as the Fed looks to do what it's going to do.

And just one quick one. When you bought Aurora they had I think that original $700 million of UPB, that was Fannie and Freddie if I recall. The discussions obviously with Freedom have all been around Ginnie Mae; so I'm just curious, are you actively as you look to deploy capital in the MSR space, are you looking at the GSEs as well as Ginnie Mae for full MSRs?

Absolutely.

Okay. Any thoughts about the relative merits of one versus the other? Is there any clear distinction, or does it all come back to just an IRR type of analysis?

Within the GSEs themselves or GSE versus --?

Just is there any risk or benefits one way or another between say Ginnie versus the GSEs as you're looking -- it's beyond my level of understanding of the nuances of MSRs, but I'm just curious whether there's something unique about Ginnie Maes that may make those more attractive than Freddie/Fannie.

I think it comes down to risk-adjusted return. And Ginnie Mae bonds, MSRs have an element of credit risk to them that I think we don't see in GSEs. And so when we look at whether to deploy capital in either Fannie/Freddie versus Ginnie, we look at a few things including the absolute level of returns, the returns on a levered basis, and the implied credit risk associated with the portfolios that we look at. And we're constantly looking at portfolios that might meet our return hurdles and our risk parameters.

I can say that we think that the market is still fully valued on the GSE front, on the Ginnie Mae space probably not as much so, maybe a function of the market trying to assess the embedded credit risk in the loans. But we are looking at all of those spaces to add to the portfolio today.

I appreciate all the comments. Thank you.

(Operator Instructions)

As there are no further questions at this time, I would like to turn the call back over to Mr. Jay Lown for closing comments.

Thanks. We know some of you are trying to get through the storm so we appreciate you guys sticking with us. I know it's late, and again we thank you for joining us on the call today, and we look forward to updating you soon on our first-quarter results.

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