Earnings Call Transcript - AOMR Q4 2022

Operator, Operator

Greetings and welcome to Angel Oak Mortgage Fourth Quarter Earnings Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Randy Chrisman, Chief Marketing Officer. Thank you, and you may...

Randy Chrisman, Chief Marketing Officer

Good morning. Thank you for joining us today for Angel Oak Mortgage REIT’s fourth quarter and full year 2022 earnings conference call. This morning, we filed our press release detailing these results, which is available in the Investors Section on our website at www.angeloakreit.com. As a reminder, remarks made on today's conference call may include forward-looking statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those discussed today. We do not undertake any obligation to update our forward-looking statements in light of new information or future events. For a more detailed discussion of the factors that may affect the company's results, please refer to our earnings release for this quarter and to our most recent SEC filings. During this call, we will be discussing certain non-GAAP financial measures. More information about these non-GAAP financial measures and reconciliations to the most directly comparable GAAP financial measures are contained in our earnings release and SEC filings. This morning’s conference call is hosted by Angel Oak Mortgage REIT’s Chief Executive Officer, Sreeni Prabhu; Chief Financial Officer, Brandon Filson; and Angel Oak Capital's Co-CIO, Namit Sinha. Management will make some prepared comments, after which we will open up the call to your questions. Additionally, we recommend reviewing our earnings supplement posted on our website at www.angeloakreit.com. Now, I will turn the call over to Sreeni.

Sreeni Prabhu, Chief Executive Officer

Thank you, Randy, and thank you, everyone for joining us today. As you all know, 2022 was a very challenging year as we battled rising inflation, heightened market volatility, and spread widening across most asset classes. The Fed approved an unprecedented seven increases to the Fed funds rate over the course of the year beginning in March. These increases took the benchmark interest rate from 0.25% as of December 31, 2021 to 4.75% as of December 31, 2022, marking its highest level in 15 years. Mortgage rates rose in kind, more than doubling and peaking about 7% in October. At the same time, non-QM mortgages approached 9%. Additionally, the securitization markets were extremely challenging, especially in the second half of the year. However, as we mentioned in our last earnings call, we commenced a strategic plan in the fourth quarter to reduce warehouse financing risk and increase liquidity. Over the last several months, we have made tremendous progress, including three key accomplishments. First, in November, we sold residential mortgage loans with a gross weighted coupon of approximately 4.5%, reducing financing risk and releasing incremental liquidity. This was a calculated decision and we found that the price we received was commensurate with the lack of liquidity in the securitization markets at that time. Second, in December and early January, we converted approximately $286 million of mark-to-market debt from non-mark-to-market financing for continually performing loans, further reducing financing risk. This facility was with one of our existing large bank counterparties, which also speaks to our strong partnerships with global banks. Finally, we participated in an AOMT 2023-1 securitization subsequent to year-end. This was the first Angel Oak securitization in which we participated alongside other Angel Oak entities since our initial public offering. We retained our pro rata share of bonds and the proceeds from the deal. As a result of this accomplishment, as of today, we have reduced our whole loan warehouse debt by over 50% and the mark-to-market percentage of total warehouse debt by over 60% since the end of Q3 2022. Additionally, it is important to note that we have not taken on any corporate debt or preferred equity and that we own the call rights to all our dealers, which gives us tremendous flexibility in the future. The goal of this strategy was not only to reduce risk and create liquidity but to also restart our growth engine. And to that end, we intend to resume purchases of newly originated loans at market interest rates. With respect to the current mortgage landscape, there are a couple of dynamics that I’d like to reiterate. First, there remains a meaningful shortage in supply of quality housing across the country. While mortgage rate increases have slowed down demand for home purchases, this underlying constraint should help support a baseline level of mortgage activity. Second, credit performance remained strong. Delinquencies remain low. Foreclosures are exceedingly rare and loss severities are near zero. Additionally, there has been significant home price appreciation since many of these loans were originated, lowering LTVs and limiting losses in the rare event of default. Even if we factor in a slight to moderate decrease in home prices this year, we still expect meaningful growth versus where loans were originated. Finally, the volatility of this past year has resulted in even higher barriers to entry for the non-QM mortgage origination business. This reinforces the competitive advantage of our relationship with Angel Oak's well-established and streamlined non-QM origination platform. Over the coming quarters, we plan to rotate our portfolio into high coupon mortgage loans and other high yielding mortgage assets and sustain a methodical securitization process, all while continuing to stress liquidity management and protect the balance sheet.

Brandon Filson, Chief Financial Officer

Thank you, Sreeni. First, I would like to talk through the details of our financial results and then provide some additional context around our current position and where we're headed. For the fourth quarter of 2022, we had a GAAP net loss of $8.8 million or $0.36 per share. The loss was driven by the November loan sale, which drove roughly $19 million of incremental loss or $0.77 per share. Distributable earnings were negative $61.5 million or a loss of $2.50 per share. The November loan sale contributed approximately $63 million of realized loss or $2.56 per share in distributable earnings. The loans sold carried an unrealized loss of approximately $44 million as of the end of Q3, all of which were realized upon the sale in addition to the $19 million incremental loss. Interest income for the quarter was $28.4 million and net interest margin was $7.4 million, which compressed due to higher variable borrowing costs. Our operating expenses for the fourth quarter were $4.3 million, representing a decrease of over $7 million from Q3. Excluding securitization and severance expenses, operating expenses were $2 million lower than Q3, which was approximately $1 million lower than Q2, demonstrating continued progress in scaling our operations. Now digging into our balance sheet. As of December 31, we had $29.3 million of cash. Our recourse debt to equity ratio decreased to 2.9 times versus 3.7 times at the end of the third quarter. We have residential whole loans at a fair value of $771 million. Finance was $640 million of warehouse debt. $1 billion of residential mortgage loans and securitization trust, and $1.1 billion of RMBS, including $62 million in retained AOMT securities from the pre-IPO securitizations. We finished the year with undrawn loan financing capacity of $573 million. And as of today, our capacity is approximately $767 million. This difference is driven by our participation in January's AOMT 2023-1 securitization, which released approximately $190 million of mark-to-market warehouse debt. As of today, we have approximately $440 million of warehouse debt, only $155 million of which is subject to mark-to-market risk. We were pleased to reenter the securitization market in January of this year. The AOMT 2023-1 securitization was an approximately $580.5 million securitization, and we contributed approximately $241 million scheduled principal balance of loans. Additionally, we retained bonds with a base value of $26.6 million and a fair value of $21.8 million while releasing $15.9 million in cash. We expect these retained bonds to yield between 10% and 15%. GAAP book value per share declined 10.7% to $9.49 as of December 31, 2022, down from $10.63 as of September 30, 2022. This includes a $0.76 impact from the November loan sale as well as the impact of our $0.32 per share common dividend paid in November. Excluding these impacts, GAAP book value was relatively flat for the quarter. Economic book value, which fair values all non-recourse securitization obligations was $13.11 per share as of December 31, 2022, up 1.3% from $12.94 per share as of September 30, 2022. The fair value of the bonds underlying our securitization obligations declined as rates increased and duration expectations lengthened, driving the increase in economic book value. Assuming that loan and security pricing has remained relatively flat so far in 2023, with January's rally being offset by a retreat in February. We estimate our GAAP and economic book value as of the end of February to be fairly flat as well, inclusive of the known impact of the dividend payment to be made in March. Looking forward, we plan to resume purchases of newly originated loans. We'll do this selectively, and we'll continue to emphasize liquidity throughout the process. Recent rate locks on the mid-8% range with average LTVs of 72% and FICO scores of 752. We believe that purchasing these loans and maintaining a methodical securitization process is the best way to organically grow the earnings potential of the portfolio. Finally, the company has declared a $0.32 per share common dividend payable on March 31, 2023, to shareholders of record as of March 22, 2023. For additional color on our financial results, please review the earnings supplement available on our website. I will now turn it back to Sreeni for closing remarks.

Sreeni Prabhu, Chief Executive Officer

Thank you, Brandon. 2022 was a year of unique challenges for the market. We faced rising inflation, higher interest rates, and recession concerns. While Angel Oak was not immune to these challenges, we acted decisively to ensure the strength of our capital structure and have positioned ourselves to restart our growth programs. As always, I would like to thank the entire Angel Oak team for their hard work and contributions as we seek to build long-term value for our shareholders. With that, we'll open up the call to your questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. First question comes from Chris Kotowski from Oppenheimer. Please proceed with your question, Chris.

Chris Kotowski, Analyst

Good morning. Thanks for taking my question. I guess just given the large number of moving parts with the sale and the securitization and so on, and given that we're like 68 days into a 90-day quarter. I wonder if you could give some guidance on expectations for net interest income in the first and or second quarter if you can see that far out?

Brandon Filson, Chief Financial Officer

Yeah. What we're seeing, we haven't added much to the portfolio with those securitization going out. The top line NIM will go down slightly. I'd expect with that securitization that the net interest margin should stay slightly compressed due to higher borrowing costs, but as we've moved another $240 million off to fixed securitization costs, we'll see some of that bleed through in NIM.

Chris Kotowski, Analyst

And you mean that in dollar terms, relative to $7.4 million, okay.

Brandon Filson, Chief Financial Officer

In dollar terms.

Chris Kotowski, Analyst

And then, okay, that's very helpful. And then presumably in the coming quarters, it will be a function of when and if you add to the balance sheet overall. And I know it's a very fluid environment, but any guesses to the likely balance sheet trends over the course of the year?

Brandon Filson, Chief Financial Officer

Yeah. We expect to get another securitization out much like we did in January. That would probably be a little bit smaller than the one we did, but reducing the whole loan balance securitizing more loans and then very soon start purchasing newly originated loans, which I think that Sreeni had mentioned in his section, are approaching 9% coupons. So as we build that balance sheet, the loan balance will come up somewhat, but we won't go as high as we did like in Q1 of '22. But as we buy those market coupon loans, you'll see both top line and bottom line NIM trend upward.

Chris Kotowski, Analyst

Okay. And then on the expenses, I mean, they had been kind of in the $4 million to $5 million range and $1.8 million this quarter. Any thought on what one should expect there?

Brandon Filson, Chief Financial Officer

Yeah. Well, the $8 million includes a decent amount of securitization cost. Going forward over the next year, looking at management fees will be decreasing. Our management fee that we pay the manager is based on the distributable earnings. So as we had distributable earnings loss this quarter, that's going to reduce. Run rate is going to go down about $1 million there. And then as some of the other things happen, we're doing a lot of analysis, and we've brought in some services that we previously outsourced at a good cost savings. You should see another, call it, $1 million in savings on a normalized basis.

Chris Kotowski, Analyst

I'm sorry, you said $8 million. I was looking at the…

Brandon Filson, Chief Financial Officer

$1 million. $1 million less on management fee and then $1 million on operating expenses.

Chris Kotowski, Analyst

And that's relative to the $1.79 million this quarter on OpEx?

Brandon Filson, Chief Financial Officer

Yes, the $1.8 million is a quarter. I'm saying annually saving us about $1 million on OpEx and $1 million on management fee.

Chris Kotowski, Analyst

Okay. Those are annual numbers, so.

Brandon Filson, Chief Financial Officer

That's right.

Chris Kotowski, Analyst

Okay. All right. Thank you. That's it for me.

Operator, Operator

Thank you. The next question comes from Don Fandetti from Wolfe Fargo. Please proceed with your question, Don.

Don Fandetti, Analyst

Yes. Can you talk a little bit about the securitization markets? Obviously, you had a little window in January, but has that shot? Do you think another deal that can get done in this type of environment? And how do you feel generally speaking about liquidity? I mean, the Fed is still raising rates, still uncertain time. Does it make sense to start originating and growing, or should you continue to just really hunker down here?

Sreeni Prabhu, Chief Executive Officer

Hey, Don. Sreeni here. I'll provide a broader overview. Through our franchise, we are managing two different securitization vehicles. The REIT was able to benefit from a strong market in January, and we have been active in the securitization markets. We completed another securitization in February through our other vehicles. Currently, the markets are a bit unpredictable, but we are seeing successful deals being made. While spreads will widen during periods of volatility, we are not facing the same level of illiquidity as we did last August through November. Additionally, there are not many new originations happening, so if buyers want to purchase bonds from the non-QM shelf, they need to act now since supply is limited. In fact, for the REIT, we have very little left until one or two more securitizations. The market is responding accordingly. While spreads may increase when issues arise, we made a final acquisition in February and plan to return to the market in March; we're already preparing for that, and the REIT will include some loans in that. This situation could shift, but at the moment, everything seems stable. Regarding liquidity, we've navigated many challenges last year. Currently, for our loans in the non-mark-to-market facility, we have a bit over $100 million in a mark-to-market facility, which presents minimal risk. We won't rush to use all our liquidity to acquire loans. As Brandon mentioned, even if we consider purchasing loans, the timeline from when they get locked to when they close means we’ll be deploying funds next month or possibly the month after, and it will be done cautiously in relation to risk and the securitization markets. For instance, if conditions in the securitization markets are unfavorable in March, we may hold back on buying new loans. We're in a solid position to manage both aspects right now, which is our focus. So please don't expect us to aggressively pursue every available 9% coupon out there.

Don Fandetti, Analyst

What is the plan in terms of a sustainable dividend level?

Brandon Filson, Chief Financial Officer

Yeah. Like we said last quarter when we did the cut from 45 to 32, we thought when we looked out at the opportunity set for 2023 that 32 would have been a sustainable level that we could maintain comfortably throughout, at least throughout the 12 months period. Always subject to review and analysis, but we are still comfortable with that as well. Like I said, when we did this last securitization, it'll function like our pre-IPO deals where we just retained bonds. Those bonds themselves that we retained have a future expected yield of between 10% and 15%. So the discount that we inherently had because of the loans marking down is basically behind us and now it's going to be a good return. Then as we start buying the new loans, building back that NIM, it looks relatively good in the couple of quarters this year, especially like, as Sreeni said, we're almost through/done with a lot of the lower coupon loans. The risk of margin calls is significantly reduced. Let me just put some numbers around it. Sreeni mentioned we have about $140 million on our mark-to-market facility, but that's down from about $1.1 billion Q1 of ‘22. So the risk is not zero, but it's significantly less than it has been in the year.

Don Fandetti, Analyst

Got it. Thanks.

Operator, Operator

Thank you. The next question comes from Matthew Howlett from B. Riley. Please go ahead with your question, Matthew.

Matthew Howlett, Analyst

Thanks. Good morning, everyone. I appreciate the opportunity to ask my question. Can you discuss the possibility of repurchasing stock at 50% of its economic book value? I understand that you are paying down the warehouse line and focusing on liquidity. Could you also share the current unrestricted cash position? Additionally, how do you weigh the decision between purchasing new loans moving forward and buying back stock?

Brandon Filson, Chief Financial Officer

We are currently analyzing the situation and have not made any decisions yet. At this moment, we see a sizable dividend yield, which could provide an immediate return through share repurchases. However, we are cautious about reducing the company's size further, as our equity capital base has decreased from around $500 million to $235 million. We want to maintain a sufficient amount of float in our stock to support trading activity. Currently, our unrestricted cash stands at about $30 million, and we also have roughly $60 million in unlevered assets, which include easily convertible bonds, as well as around $18 million in unlevered loans that we could leverage or sell with relative ease.

Matthew Howlett, Analyst

No. You did a great job getting another warehouse line and paying it down and trying to look forward for the next securitizations. It's great that you have access to it, it's a big step. And then on that note, I mean, could you just address, I mean, you talked about credit and the embedded HPA, but I think for investors, non-QM is getting a lot of press. It's always the sort of area that people are cautious about 2023. And I know non-QM is a broad vector. And could you just talk about where your non-QM is in terms of credit versus maybe the overall industry and why you feel that it's going to hold up better than just generic non-QM?

Sreeni Prabhu, Chief Executive Officer

Sure. We've always made it clear that the current non-QM market differs significantly from the subprime situation of 2007. With comprehensive credit underwriting, loan-to-value ratios in the 70s, accurate appraisals, and other rigorous standards in place, the risk of default is reduced. That said, if we encounter a deeper recession, we understand that delinquencies and defaults may occur as part of the economic cycle; it’s just a question of when and how they will materialize. Importantly, our new loan originations have shown a notable improvement in credit quality. We have nearly reduced our investor cash flow loans and we are not engaging in high loan-to-value lending at all. Our current origination practices are extremely conservative. While we believe the credit quality is strong, we recognize the need to further tighten our credit standards as we approach a potential recession, and we are mindful of this. Namit, you may have additional insights since you engage with the mortgage company about credit on a daily basis.

Namit Sinha, Co-CIO

Sure. Yes. To Sreeni's point, there is an aspect of mortgage credit about the quality of loans that you originate. So when we talk about our average FICO scores being 740 plus and our average loan to values in the low-70s, these attributes look similar to agency originations, quite different from the historical knowledge and originations that used to happen in the pre-global financial crisis period. These loans have performed really, really well. They've hardly had any losses in the last seven or eight years of our originations. Now, if we do go into a bumpy macro environment, as Sreeni mentioned, we do expect some increase in delinquency. But practically, if you have a book with delinquency rates running in the 1% range, and we go into a recession and that delinquency increases by 50%. You are still talking about a delinquency that is close to 2%, which is not a huge distraction from the return potential of these loans, especially when you think of the loan coupons that are being originated. We’re talking about a 9% coupon being originated with a 740 plus FICO and 70 LTV. If delinquency rates rise from 1% to 2%, it does not take much to calculate an overall reduction in yield. So yes, in any macro environment that heads into a recession, no matter what the quality of the loans, you're going to see a percentage increase in delinquencies. However, given our platform, the loan origination practices, and the quality of these loans, we don’t expect it to be akin to some of the earlier non-agency programs from prior tough periods.

Matthew Howlett, Analyst

Yeah. I see the disconnect between what you're seeing and what the market is anticipating. Last question, just a quick update on Angel Oak Mortgage to the mortgage company? Do you feel like the right size, the platform? Do you feel like it's in position to grow in 2023?

Sreeni Prabhu, Chief Executive Officer

Yeah. I'll take that one. Yeah. I mean, there's a lot of conversations about the Angel Oak Mortgage Company. Just to reiterate, we had two mortgage companies. So one is important for this discussion and one was just a business venture we had. So we had a retail mortgage originator, which was largely an agency mortgage originator. And that's where we had some of our licenses. That's the business we dramatically reduced because it was not a non-core function. We made a good amount of money in 2021, but the market got really tough in 2022 and that was not the business we really wanted to be in. In terms of non-QM, which really came from our wholesale mortgage originator, which is mortgage solutions, the majority of our infrastructure is exactly the same. It’s not any different. We made, of course, every mortgage company has gone through cost-cutting, but we do really have not much risk on our balance sheet. We are originating a volume here and the flow-through coupons are approaching 9% as we speak. However, volumes have dropped and they're probably going to end up being half of what they were early last year. But what we're focused on right now in the mortgage company is not volume. It's more about volume and credit, and that's what we are focused on without making any major changes from that perspective.

Matthew Howlett, Analyst

Great. Thanks, everyone.

Operator, Operator

Thank you. There are no further questions at this time. I'd like to turn the call back to management for closing remarks. Thank you.

Sreeni Prabhu, Chief Executive Officer

Thank you, everyone for your time and interest in Angel Oak Mortgage REIT. We look forward to connecting with you again next quarter, please feel free to reach out to us and we invite you to our offices anytime you'd like to visit. Thank you so much. Bye.

Operator, Operator

Thank you very much. Ladies and gentlemen, this does conclude today's call. Thank you very much for your time. You may now disconnect your lines.