Earnings Call Transcript - CHMI Q1 2022

Operator, Operator

Greetings. Welcome to the Cherry Hill Mortgage Investment Corporation First Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host Garrett Edson, you may begin.

Garrett Edson, Host

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's First Quarter 2022 Conference Call. In addition to this call, we have filed a press release that was distributed earlier today 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, internal rates of return, future expected cash flows, as well as prepayment and recapture rates, delinquencies and non-GAAP financial measures such as earnings available for distribution or EAD, 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 presentations available on the company's website. Today's conference call is hosted by Jay Lown, President and CEO; Julian Evans, the Chief Investment Officer; and Michael Hutchby, the Chief Financial Officer. Now, I will turn the call over to Jay.

Jay Lown, President and CEO

Thanks, Garrett, and welcome to today's call. The first quarter was certainly eventful for both Cherry Hill and other agency-focused REITs, as markets endured the considerable widening of mortgage spreads, inflation hitting 40-year highs, a war in Eastern Europe, and continued market concerns about supply chains not being at full capacity. As the Fed began to telegraph its strategy to fight inflation, rates spiked meaningfully during the quarter and that has further progressed into May. The US 10-year treasury finished the quarter at 2.34%, 83 basis points above year-end. At the same time, economic data held the line for the most part with unemployment remaining near historic lows, and we are close to full employment levels. The Fed has signaled significant rate hikes in the months ahead to combat high inflation, starting with a 50 basis point move last week. Markets globally are digesting the velocity of future hikes and the Fed's intentions around reducing its balance sheet. We are actively adjusting our investment portfolio as we evaluate the impact these actions will ultimately have on the broader economy, as well as mortgage-related assets. For the quarter, improving prepayment speeds continue to aid our earnings available for distribution or EAD, a non-GAAP financial measure. In the first quarter, we generated GAAP net income applicable to common stockholders of $25.6 million, or $1.40 per share, and EAD of $6.2 million, or $0.34 per share, exceeding our quarterly dividend level of $0.27 per share. On an annualized basis, our dividend yield is 16% based on the recent average of our closing price of our common stock. As a reminder, EAD is just one of several factors we consider in setting our dividend policy. Book value per common share finished at $7.27 as of March 31. During the quarter, we reduced the size of our RMBS portfolio in an attempt to mitigate the impact of spread widening and minimize the impact on book value and NAV. Spreads widened during the quarter, on average about 25 basis points, which accounted for nearly three-quarters of the decline in book value in this period, in line with our previously provided fourth quarter basis risk sensitivity profile. We were able to stabilize the book value reduction in March, and we are pleased to report that the book value was up slightly in April. Julian will provide more details on our portfolio performance shortly. As a reminder, our current book value performance per common share is a function of preferred stock making up a significant portion of our overall equity profile. On a net asset value basis, which doesn't account for the difference between common or preferred equity, our performance in the quarter was more effective, with NAV down approximately 8% quarter-over-quarter, before taking into account any common stock issuances pursuant to our ATM program. We believe our NAV performance shows our strategy of pairing RMBS with agency MSRs partially mitigated the full effect of spread widening in Agency RMBS. That said, we remain committed to stabilizing and growing our NAV and book value. We continue to be constructive on MSRs, given our view on interest rates over the near term, and they provided a good amount of assistance relative to our book value performance in the quarter. We would note, however, that with the 10-year at the 3% mark, the ability for the MSR portfolio to continue to hedge the RMBS portfolio begins to become less effective, as the current coupon for Agency RMBS is now well above the weighted average note rate of our MSR portfolio. That said, we continue to believe MSR and RMBS assets complement each other well. As a result, we expect to remain disciplined in our approach to investing in MSRs given the rise in rates, the competition, and robust pricing. As prepayment speeds further decline in a higher rate world and behavioral modeling risk increases, we continue to believe the best approach remains being selective in adding or replenishing MSR assets. During the first quarter, we acquired approximately $500 million UPB in Fannie and Freddie MSRs via flow purchases. As noted before, we continue to believe the strategy of marrying MSRs with Agency RMBS provides for attractive risk-adjusted returns and aids in protecting the portfolio from the full extent of current coupon spread widening. At the end of the quarter, leverage was 3.6 times, comparable to the end of the prior quarter. We ended the quarter with $52 million of unrestricted cash on the balance sheet, maintaining a solid liquidity profile. Our recapture efforts remain strong with a 19.6% recapture rate on our MSRs in the quarter. Recapture rates should continue to decline as mortgage rates rise, though prepayment speeds net of recapture should continue to improve. Looking ahead, as the Fed continues meaningfully tightening rates and providing greater clarity around its balance sheet reduction program, we believe the mortgage basis should stabilize later in the year. Our intention is to raise leverage back to more historical levels and to take advantage of opportunities in Agency RMBS as spreads normalize and rates begin to peak. In the meantime, we continue to keep a firm hand on our balance sheet. And when we see attractive investment opportunities, we will look to invest prudently. With that said, I'll turn the call over to Julian, who will cover more details regarding our investment portfolio and its performance over the first quarter.

Julian Evans, Chief Investment Officer

Thank you, Jay. The first quarter was characterized by a rising rate environment that had long been anticipated. As inflation took center stage and the Fed signaled a clear shift in its policy in order to fight inflation and reduce its balance sheet, the assumption of pending rate hikes was known to the market. However, the pace and the size of future hikes is still very much uncertain, which is evidenced by the broad range of forecasts produced by market fundings, as the Fed works to return inflation to neutral and to engineer a soft landing for the US economy. In March, the Fed took its first step by hiking rates 25 basis points. But with the Fed Chair noting that taming inflation is absolutely essential, we were not surprised to see the Fed hike rates an additional 50 basis points last week, and we expect there will be many more to come in the coming months. In the meantime, the market has attempted to get ahead of the Fed and has priced in multiple rate hikes for this year. At quarter end, MSR had a UPB of $20.4 billion and a market value of approximately $246 million. During the quarter, we purchased approximately $500 million UPB of new MSRs to our flow programs, as Jay mentioned. At the end of the first quarter, the MSR portfolio represented approximately 45% of our equity capital and approximately 21% of our investable assets, excluding cash. Meanwhile, our RMBS portfolio accounted for approximately 40% of our equity. As a percentage of investable assets, the RMBS portfolio represented approximately 79% excluding cash at quarter end. During the quarter, we continued to experience CPR improvements in both our MSR and RMBS portfolios. Our MSR portfolio, net CPR averaged approximately 15% for the first quarter, down materially from approximately 19% net CPR in the previous quarter. The decline was driven by the rapid rise in interest rates, which resulted in the mortgage production coupon escalating from 2.5% to 4% in less than 90 days. The reduction in MSR CPR was supported by the rapid change in mortgage production coupons, which drove slower prepayment speeds in the quarter, as well as a relatively solid recapture rate of 20% versus 23% in the fourth quarter. Going forward, we should expect a lower recapture rate but stable or improved net CPR, given the escalated levels of interest and mortgage rates. Similarly, the RMBS portfolio prepayment speeds exhibited the same themes. The portfolio's weighted average three-month CPR reduced to approximately 11% in the first quarter, compared to approximately 12% in the fourth quarter. As mortgage rates have moved higher, mortgage securities have become less refinanceable. As of today, nearly the entire mortgage universe is out of the money in terms of refinancing. We would expect prepayments to continue to slow, but again to form a foundation if we remain at these levels of interest rates or higher. As of March 31, the RMBS portfolio, inclusive of TBA stood at approximately $940 million, compared to $1.4 billion at the previous quarter end. The reduction was driven by the selling of securities, rising interest rates, as well as mortgage spread widening. Quarter-over-quarter, the size of the RMBS portfolio was reduced to lower basis risk and protect book value as interest rates rose. Both TBA and specified pools were sold during the quarter to limit exposure. As an offset, we did reinvest some of the proceeds into this higher-yielding lower dollar price environment. At the end of the first quarter, the 30-year securities position represented 94% of the RMBS portfolio, versus 89% at the end of the fourth quarter. Shorter duration securities made up a smaller portion of the RMBS portfolio, with 20-year securities and other collateral positions representing 6% of the portfolio at quarter end. For the first quarter, we posted a 3.06% net interest spread versus a 2.46% net interest spread reported for the fourth quarter, driven by a continuation of better prepayment speeds. The spread was also aided by improved interest expenses on our payer swaps, which offset higher repo costs. At quarter end, portfolio leverage stood approximately 3.6 times at the aggregate level. Looking forward, the Fed is still at the beginning of the fight to minimize inflation. As of last Wednesday, the Fed hiked rates for only the second time this year, and has just announced and laid out its plan for reducing its balance sheet. For now, the market has front-run the Fed, expecting it to raise the Fed fund rate the equivalent of an additional 175 basis points this year to combat inflation. We are focused on the Fed's ability to achieve its goal of fighting inflation while maintaining solid GDP growth, which will be a delicate balance at best. We expect elevated levels of volatility and limited liquidity in the market. And as such, we will continue to evaluate and alter the portfolio as necessary as the year progresses. I will now turn the call over to Mike for our first quarter financial discussion.

Michael Hutchby, Chief Financial Officer

Thank you, Julian. Our GAAP net income applicable to common stockholders for the first quarter was $25.6 million or $1.40 per weighted average share outstanding during the quarter, while comprehensive loss attributable to common stockholders, which includes the mark-to-market of our held-for-sale RMBS, was $17.9 million or $0.98 per share. Our earnings available for distribution attributable to common stockholders was $6.2 million or $0.34 per share. Our book value per common share as of March 31st was $7.27, compared to a book value of $8.56 as of December 31st. We use 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 first quarter, we held interest rate swaps, swaptions, TBAs, treasury futures, and options on treasury futures, all of which had a combined notional amount of $1.4 billion. You can see more detail with respect to our hedging strategy in our 10-Q, as well as in our first quarter presentation. For GAAP purposes, we have not elected to apply hedge accounting for our interest rate derivatives. As a result, we record the change in estimated fair value as a component of the net gain or loss on interest rate derivatives. Operating expenses were $3.5 million for the quarter. On March 10th, our Board of Directors declared a dividend of $0.27 per common share for the first quarter of 2022, which was paid in cash on April 26th. We also declared a dividend of $0.5125 per share on our 8.2% Series A cumulative redeemable preferred stock, and a dividend of $0.515625 on our 8.25% Series B fixed to floating rate cumulative redeemable preferred stock, both of which were paid on April 18th, 2022. At this time, we will open up the call for questions.

Operator, Operator

At this time, we will be conducting a question-and-answer session. Our first question comes from the line of Mikhail Goberman with JMP Securities. Please proceed with your question.

Mikhail Goberman, Analyst

Hi, good afternoon gentlemen. You guys said book value was up slightly in April. I'm wondering what would you describe as relatively good performance attributable to?

Jay Lown, President and CEO

So, Julian, do you want to talk about that?

Julian Evans, Chief Investment Officer

Sure. I mean, look, I think some of it has to do with coupon positioning. As we moved into the second quarter, we have a little bit more focus being up in coupon. We also have some short positioning there in terms of the lower coupons. I'd also say we had pretty good swap hedges on, especially in the front part of the curve as things were moving higher. We also had some additional futures hedges on in the portfolio, and they were mainly in the back part. Our MSR also rose in value during that time. So, I think it was just a good combination of being properly hedged for what we thought was going to happen in April and tactically executing that.

Mikhail Goberman, Analyst

Well done and best of luck in continuing that performance. I'm wondering how much spread widening do you guys think is still possible in MBS and also kind of parallel to that maybe how much sensitivity MSR values have to further spread widening or moves up in rates?

Jay Lown, President and CEO

You want to talk about the MBS side, I'll take the MSR side, but Ray, can you start off on the MBS?

Julian Evans, Chief Investment Officer

Yes. In terms of what investors are trying to understand about the Fed's definition of neutral interest rates, the market is seeking some stability. We find mortgages quite appealing at this moment, although there is heightened volatility. The ongoing sell-off has made them attractive from both a yield and price standpoint, as well as on a LIBOR OAS basis, but there is still potential for further movement. If the market believes that the Fed may have several more rate hikes ahead of reaching neutral, they likely see neutral as being around 2.5% to 2.75% in interest rates. Additionally, they have indicated plans for some hikes in fiscal year 2023. Therefore, if we need to move significantly above neutral, we could expect at least another 15 to 20 basis points widening in mortgages. However, if we can achieve some stability in rates, perhaps around this level or near 3.50%, then we may see some support, allowing mortgages to start firming up.

Jay Lown, President and CEO

Ray, do you want to talk about the MSRs?

Ray Slater, Analyst

Sure. I mean, on the MSR front, I think given the speed at which we saw rates rise, it's really dampened the impact from the prepayment slowdown due to spread widening on coupons that are now 100 basis points out of the money. I suspect as the year goes on and new acquisitions occur that are more towards where par sits today, which is low-5s. That will start to grow again. But right now, with the speed of how quickly everything happened, I think even production coming in the door right now is like a 4.5% note rate, which sits 75 basis points below par.

Mikhail Goberman, Analyst

All right. That's helpful. Thank you. And one more if I could just a housekeeping question. I know your queue is probably coming out soon, but is there any change to the DTA level from $20.6 million at the end of the year?

Michael Hutchby, Chief Financial Officer

Yes. The DTA's down to approximately $16 million at the end of Q1.

Jay Lown, President and CEO

It was $16 million and change at the end of Q1.

Mikhail Goberman, Analyst

All right. Thank you very much, guys.

Jay Lown, President and CEO

No problem.

Operator, Operator

Our next question comes from the line of Henry Coffey with Wedbush. Please proceed with your question.

Henry Coffey, Analyst

Good afternoon, everyone, and thanks for taking my call. So I'm looking at slide 15 in your deck, which is very instructive. But the thing that sticks out is that when you talk about book value change and interest rate sensitivity, that the big problem is basis risk; in other words, spreads widening. If I'm reading this correctly, you're saying that if basis stays the same, book value stays the same at 727. A 25 basis point widening would take book value down to 647. Is that a real possibility? It does sound like something that hasn't occurred because your book value is up a little bit, but could occur. And then the offset from rates just isn't that large.

Jay Lown, President and CEO

100%. The rate sensitivity is significantly less than the basis risk. It has always been that way. Nobody really focused on it when the Fed was tightening or easing over the last two years. A lot of book value gains for agency REITs during that time were attributable to spread tightening. Regardless of how the message was portrayed, the reality is that a lot of risk resides in basis risk exposure because it's not something that traditionally agency REITs hedged for in a significant way. So if the question is how much do we think there is to go? Julian tried to give you some feel for what might happen. Look, a lot of this is Fed dependent with respect to the market's comfort level about how this is landing and terminal rates going into the tightening. While they seem to be doing a better job today of conveying their intentions, a lot of things could impact what they do going forward relative to growth, recession, macroeconomic events, the war in Ukraine. So we're just trying to manage through that from the perspective of trying to understand what the right hedge ratio is for the assets in terms of where they could fully extend to, as well as managing what we think the contribution from the MSR is to offset some of that, which I mentioned in my script; as we approach 3% on the 10-year, the ability for the MSR to assist in limiting the effect of spread widening decreases, based on the fact that the current coupon is, as Ray mentioned, somewhere in the 4s versus the current coupon in our portfolio, which is in the mid-3s. Does that help? There's no real...

Henry Coffey, Analyst

Yes. No, how aggressive are you willing to be in terms of leaning in one direction or another? Put differently, how aggressive would you be on the MSR book given that rates are moving higher?

Jay Lown, President and CEO

In terms of mortgages...

Henry Coffey, Analyst

Mortgage rates are moving higher and I know it gets more complex after that.

Jay Lown, President and CEO

I don't understand the word 'aggressive.' Aggressive in what sense?

Henry Coffey, Analyst

Buying more MSRs with more leverage and selling down RMBS. In other words, increasing the mix of MSR, selling RMBS, buying more MSRs either with additional leverage or through liquidating the other side of the business. So I would describe getting more aggressive on MSR simply as buying more. Okay. And I'll let you have the details.

Jay Lown, President and CEO

Sure. Given that approximately 40% of the equities in the asset, there is no real desire to take it to say 60% today. But we do have an interest in acquiring servicing assets that we think can harvest return hurdles in terms of characteristics that we like. We don't have any intention to sell a significant portion of that portfolio today. One of the hardest things we will tell you about MSRs is managing prepayment risk. Given that the portfolio has a weighted average note rate that's low today, that's great for cash flows. This is critical, but what we have done, which I think probably hasn't gone unnoticed, is we've reduced the size of the RMBS portfolio significantly. We have reduced the size of that RMBS portfolio by a couple of hundred million over the last four months in an effort to kind of reduce our exposure to the basis. Should we feel that we have more to go, it wouldn't surprise me if we made a decision to do that more aggressively.

Henry Coffey, Analyst

And where would the cash go? There's some cash that comes out of that I’m looking at your numbers.

Jay Lown, President and CEO

The leverage on that is obviously higher. The cash may be held in cash or we might buy some MSRs. However, we believe that at some point during the year, these mortgage spreads will normalize. As mentioned in the script, we plan to return to that space fairly aggressively and look to invest capital in that area.

Henry Coffey, Analyst

Great. Thank you.

Operator, Operator

Our next question comes from the line of Matthew Howlett with B. Riley. Please proceed with your question.

Matthew Howlett, Analyst

Hi, Jay, hi, everybody. Thanks for taking my question.

Jay Lown, President and CEO

Hi, Matt.

Matthew Howlett, Analyst

The first on the net CPR for the MSRs was 12.7%. I know the recapture came down, but the overall CPR came down. My question to you is where could that go? First, where could gross CPRs for MSRs go? Could it be 5%, 6% CPR? And kind of how far low could the net CPR go on that portfolio?

Jay Lown, President and CEO

Well, I'll try to get Ray to limit the amount of time he'll spend on this because he could spend half an hour talking about that. But Ray, tell Matt, what you think based on our portfolio and how you think the speed and short-term speeds could go relative to the current portfolio?

Ray Slater, Analyst

Yeah. I mean, I think that I look back to prior to the pandemic in 2017 or 2018 when rates were rising and we actually had out-of-the-money MSRs and where were print back then and they were definitely in the mid- to high single-digits. And those were not nearly as out of the money as the portfolio sits today. I'm always hesitant to think six is possible, but it does seem like it’s in the realm of possibilities given that everything is 150 basis points out of the money or more.

Matthew Howlett, Analyst

Okay. So you said five or six recapture possible.

Ray Slater, Analyst

Yeah. I suspect recapture will become quite negligible and CPR on a gross basis will just sit around the mid-singles, both on gross and net.

Matthew Howlett, Analyst

So from a P&L perspective, if I look at that servicing fee income and the servicing income line was up a little. Servicing cost line was up a little bit. It improved sequentially, holding everything constant like the portfolio. Should we expect that line item, that net service income, to continue to improve? As speeds and amortization continues to go lower and lower?

Ray Slater, Analyst

Well, I mean from an improvement standpoint that line item is largely driven by the size of the portfolio. So it's a 25 basis point strip essentially on the UPB. So as far as the UPB increasing, that drives it higher. But a slowdown in speeds just means that your rate of decline diminishes. It doesn't necessarily mean that it's going to grow.

Matthew Howlett, Analyst

Okay. You're modeling it, and you're running at a speed.

Ray Slater, Analyst

Correct.

Matthew Howlett, Analyst

Okay. So I'm just trying to get... I guess where I'm going with is I want to go to the RMBS portfolio. You did a 300 basis point plus spread and it's one of the highest I've seen in the space. So congrats to you and the team. I guess where I'm going with, do you think will that come in as the Fed as repo cost, or do you have that hedged out?

Julian Evans, Chief Investment Officer

I mean, our swap position is going to offset that once some of the payer swaps reset. Do I know if it will be a perfect 1:1? There's always a lag of two to three months each time the swaps reset to where the Fed is moving the Fed funds. Right now, it looks like it's moving in tandem. Our interest expense is kind of declining a little bit, so at least holding flat. So for the moment it looks pretty good. But I would say, as we get to a point of where we believe there is a high in rates, we will make some changes to the portfolio.

Matthew Howlett, Analyst

It seems that you have a solid earnings available for distribution and are adequately covering the dividend while offering a high return on equity to common shareholders. This situation appears stable, but I'm curious about your perspective on the current environment. How do you view your book position right now? Do you believe you can maintain a strong earnings EAD number in the near term?

Jay Lown, President and CEO

Yes. Regarding the question about the security of the dividend in the near term, it largely depends on the pace at which the Fed tightens and how that affects our funding costs. Thus far, things have been favorable for us. The Fed does not seem to be intending to implement significant rate hikes. If the Fed maintains a stable approach to this tightening cycle, the Board will certainly consider this when determining the appropriate dividend level for the company.

Matthew Howlett, Analyst

I understand. When considering the trade-off, it's clear that a high teens yield isn't adequately compensated, so we would prefer to concentrate on increasing equity value. Do you have any preferred options, or are they callable? The market is broad, but looking ahead for the company, would you prefer to focus on growing book value and retaining more income? I know there are certain restrictions on that, but I'm just curious.

Jay Lown, President and CEO

Yes. Look, so I'm not going to speak for the Board on the call. But what I can tell you is everything that you just mentioned is discussed and has been discussed at the Board meetings, and we meet again in June. I imagine it will be another pretty healthy conversation.

Matthew Howlett, Analyst

Great. And then Jay just one broader question on the mortgage industry with excess capacity and where we are. Any just sort of thoughts on how high mortgage rates could go and just the general health of the U.S. mortgage industry given your involvement in it?

Jay Lown, President and CEO

Yes. So good question. I don't spend a ton of time on the origination side. Obviously, originator volumes are down meaningfully and they're very focused on cutting costs and margins. It will be interesting to see how all these originators do post-March relative to the most recent uptick in rates and what they're planning on doing to cut their margins to maintain volume or whether they start to operate more conservatively. We've seen some decent layoff announcements. We've seen some companies come out and say publicly that they're not planning on laying off. But we're definitely seeing through the daily origination volumes some decent drops in volume on a regular basis. From the feedback we receive in the space, while volumes had maintained themselves fairly well through April, many indicated it was just a delay in the timing of pipelines that were started towards the beginning of the year. Our expectation is that volumes will continue to drop on the origination side, and originators will be forced to make some pretty hard decisions regarding profitability, but I say that mostly in the conventional space, as we don't closely follow the Ginnie Mae space.

Matthew Howlett, Analyst

Could you discuss the bulk market at all? Additionally, do you anticipate any packages being released? I know pricing seems quite high right now, but I'm curious about that aspect.

Jay Lown, President and CEO

Yeah, right. We follow the bulk market, and we've been active in the bulk market recently. But Ray, do you want to spend a second talking about the bulk market?

Ray Slater, Analyst

Sure. Definitely, I've seen a lot of volume come out this year. It has been a little bit difficult from the standpoint of we talked earlier about utilizing MSR for spread widening and the protection benefits there. Everything that's been coming to market has been originated in the last 12 months, so there's nothing that is not fully priced or very close to fully priced. That's not been our strong interest to double down there. I think from the flow space or as we see originations coming out right now, they will probably go into the bulk market over the next few months. I think that's where our interest lies more in terms of the risk-return profiles of MSRs. Definitely, there’s a lot of bulk volume out there, and if you're confident with the CPRs at seven for Life, it's there for the taking.

Matthew Howlett, Analyst

That's a good point. So what you're saying is that with the current coupon now on the MSRs, that could be interesting down the road based on the newer production in terms of looking at those and analyzing those speeds differently than what's already been originated.

Ray Slater, Analyst

Yes, exactly.

Matthew Howlett, Analyst

Great. Well, thanks, everybody.

Operator, Operator

We have reached the end of the question-and-answer session. I'll now turn the call back over to Jay Lown for closing remarks.

Jay Lown, President and CEO

Thank you, operator. Thank you everybody for joining the call today. We look forward to talking to you in a few months to report on our second quarter results. Have a great evening.

Operator, Operator

And this concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.