Earnings Call Transcript - CHMI Q2 2020

Operator, Operator

Greetings. Welcome to the Cherry Hill Mortgage Investment Corporation Second Quarter 2020 Earnings Call. At this time, all participants are in 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, Rory Rumore. You may begin.

Rory Rumore, Host

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's Second Quarter 2020 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. 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 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, Rory, and welcome to today's call. We hope you and your families are remaining safe and healthy; we appreciate you joining us this afternoon. I'd like to begin the call by thanking our entire team for their continued efforts to manage through what has been a most challenging environment these last five months. Their hard work and dedication impresses me every day. The team continues to work remotely with no disruption in productivity. The second quarter could be described as a rebuilding period, where we work to stabilize our portfolios and closely monitor our risk as the pandemic continued to greatly impact the economy. The U.S. experienced record high unemployment numbers paired with record low GDP, keeping rates near historic lows throughout the second quarter, yet equities pushed higher in anticipation of COVID vaccines and better economic times. As we noted on our prior call, liquidity was of paramount importance as we navigated through these challenges, and we stayed focused on our core strategies and competencies throughout the second quarter. We remain committed to our portfolio as constructed with both RMBS and MSRs and believe the two asset classes provide investors with compelling returns and together effectively hedge book value, across multiple interest rate scenarios. In the midst of the pandemic, we overcame many challenges, and I am pleased with our performance for the second quarter. We reduced the leverage on our aggregate portfolio from five times at the end of March to 4.4 times at the end of June and ended the quarter with $94 million in unrestricted cash on the balance sheet. For the second quarter, we earned core income of $0.47 per share. From a book value per common share perspective, we finished the quarter at $13.41 as of June 30, a 2.3% reduction from where it stood on March 31. However, I want to emphasize that the large majority of the reduction was the result of paying 50% of our first quarter common dividend in stock during the worst of the crisis. Absent the stock dividend, book value for the second quarter was essentially flat. We accomplished all of this without having to dilute shareholders by taking on any additional financing. Year-to-date, our book value per common share is down a little less than 23%. As a hybrid REIT that invests in MSRs, which have been significantly affected by falling rates along with the unprecedented macroeconomic environment in recent months, we believe our overall book value performance thus far in 2020 stands up very well relative to other hybrid REITs that have seen greater deterioration in value since the outset of COVID. During the quarter, we made the decision to sell our Ginnie Mae MSRs. We had not grown that portfolio since the initial purchase several years ago, and given the current collateral characteristics and expected future performance, the sale was strategically appealing. We recognized a small gain versus the portfolio's fair value at June 30. Our remaining Fannie and Freddie MSRs continue to experience highly elevated prepayment fees, as expected, given the current interest rate environment. As of the end of July, active forbearance remained just shy of 8% with approximately 30% of borrowers having made all payments due through July. Going forward, we believe our bolstered liquidity position is sufficient to satisfy all of our servicing advance obligations over the foreseeable future. As we move into the second half of 2020, interest rates remain near historic lows, as markets await a vaccine. We are three months from a presidential election, which will undoubtedly heat up, and there is still double-digit unemployment. The Fed has communicated that they are prepared to do whatever it takes to keep the economy strong. Housing remains a bright light, despite high forbearance statistics. We are content to keep our powder relatively dry as we seek further clarity on the pace of the recovery. We continue to believe MSRs look compelling at current levels. And if they meet our measured risk-reward criteria, we will selectively invest through our full program. All in all, our team's efforts remain squarely focused on proactively managing our portfolio, keeping our balance sheet strong, and preserving our book value to enable us to emerge from the pandemic to take advantage of the opportunities we believe will be present once the economy rebounds. With that, I'll turn the call over to Julian, who will cover more details regarding our investment portfolio and its performance over the second quarter.

Julian Evans, Chief Investment Officer

Thank you, Jay. During the second quarter, spread sector markets improved as liquidity returned and spreads tightened on the heels of Fed policy. Those policy actions allowed us to continue to adjust our positioning to reduce leverage and maintain a high cash position. As the third quarter begins, continued Fed policy is the one constant. U.S. growth and unemployment remain uncertain, as the coronavirus weighs on the U.S. and global economies. A viable vaccine would aid consumer sentiment and confidence and would comfortably allow employees to return to work and improve growth prospects. The timing of such is unknown, but we are hopeful that something materializes in the latter part of the year. Servicing-related investments comprised of full MSRs at a UPB of approximately $24 billion and a market value of approximately $177 million at quarter end. MSR investments represented approximately 37% of our equity capital and approximately 10% of our investable assets excluding cash. Meanwhile, our RMBS portfolio accounted for approximately 39% of our equity, a slight decline from the previous quarter. As a percentage of investable assets, RMBS represented approximately 90% excluding cash at quarter end. Our conventional and government MSRs, CPRs averaged approximately 38% and 28%, respectively, for the second quarter. Speeds were elevated from the first quarter given historically low interest rates and mortgage rates. Similar to MSR speeds, the RMBS portfolio posted a weighted average three-month CPR of approximately 13.7%, elevated from the prior quarter. Despite the decreased prepayments, the RMBS speeds remain better than Fannie Mae aggregate speeds for the quarter. As of June 30, the RMBS portfolio stood at approximately $1.5 billion. During the second quarter, we further repositioned and delevered our portfolio to maintain our liquidity position. Quarter-over-quarter the 30-year securities position of the RMBS portfolio grew to 95%, a slight increase from 93% as of March 31, and the remaining assets represented 5%. For the second quarter, we posted a 1.64% RMBS net interest spread versus a 1.25% net interest spread reported for the first quarter. The improvement in spread was due to significantly lower repo cost in the quarter and resetting our swap hedges to lower rates. During the quarter, our repo cost improved from 1.62% to 0.39%, as interest and mortgage rates remained at historically low levels. Mortgage prepayments will be the main driver of the net interest spread going forward. At quarter end, the aggregate portfolio operated with leverage of approximately 4.4 times down from 5 times the prior quarter. We ended the quarter with an aggregate portfolio duration gap of positive 0.19 years. We continue to evaluate and manage the portfolio as necessary as we move forward. I'll now turn the call over to Mike for our second quarter financial discussion.

Michael Hutchby, Chief Financial Officer

Thank you, Julian. Our GAAP net loss applicable to common stockholders for the second quarter was $12.4 million or $0.73 per weighted average share outstanding during the quarter. While comprehensive income attributable to common stockholders, which includes the mark-to-market of our held-for-sale RMBS was $3.1 million or $0.18 per share. Our core earnings attributable to common stockholders were $7.9 million or $0.47 per share. As Jay mentioned, our book value per common share as of June 30, 2020 was $13.41, a reduction of $0.32 per share from March 31, 2020, net of the second quarter 2020 dividend. As we noted on our prior call, the accounting impact of paying half of our first quarter common dividend in shares of common stock was recognized in the second quarter, and that encompassed the large majority of our book value reduction from March 31. Excluding that impact, book value was relatively comparable with the prior quarter. 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 second quarter, we held interest rate swaps, swaptions, TBAs, and treasury futures, all of which had a combined notional amount of $2.1 billion. Beginning with this quarter, we're providing more granularity with respect to our hedging strategy, which you can see in our 10-Q as well as in our second quarter presentation. For GAAP purposes, we've 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. Operating expenses were $3.4 million for the quarter. On June 18th, we declared a dividend of $0.27 for the second quarter of 2020, which was paid in cash on July 28th, 2020. 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 July 15th, 2020. 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 is from Tim Hayes with B. Riley FBR. Please proceed with your question.

Mike Smyth, Analyst

Hey guys. This is actually Mike on for Tim. Congrats on your quarter. So, my first question is that core EPS is well ahead of the dividend again. I guess just first question would you expect core earnings to exceed the dividend again in 3Q assuming there's no other major economic deterioration?

Jay Lown, President and CEO

Hey, how are you? It's Jay. It's possible. As others have observed this quarter, we utilize various metrics to assess the company's earning capacity. Core is one of the main ones, but we also consider other ways to evaluate the true earnings power of the company. Right now, we feel confident in our position, but there's a chance that core could exceed expectations.

Mike Smyth, Analyst

Got you, that's helpful. And then another question is that given where MBS spreads are and just the fact that it's become cheaper to hedge and your current amount of liquidity, I know you mentioned in your prepared remarks, Jay, that you intend to maintain dry powder. I'm just wondering what would need to change for you guys to decide to get a little more offensive.

Jay Lown, President and CEO

Yes. Broadly speaking I think hybrid REITs are holding on to more cash than agency REITs in light of some of the investments that they hold. So, I would say that our desire to hold more cash is not a reflection of our view on any one specific asset, but a reflection of our ability to maintain a strong balance sheet still just a few months after what happened last time. Again I would also emphasize that we've significantly reduced the size of our non-agency position. So today the position really comprises of agency RMBS which is very liquid and very transparent pricing-wise than MSRs. Given where we are with forbearance, we think our forbearance statistics are very good relative to what we thought might happen. So as we get more clarity into what we think might happen going into the fall, I would expect that we could pare down that cash position. But it really isn't a function of a lack of desire anywhere to invest, just more a function of trying to maintain a strong balance sheet.

Mike Smyth, Analyst

That's helpful. Thank you. And then, one more question regarding speeds. At a high level, considering the outlook for the second half of the year, what do you anticipate in terms of speeds if the primary rate increased by another 30 or 40 basis points to 2.5%? How sensitive do you think speeds would be to that decrease?

Julian Evans, Chief Investment Officer

Hi, this is Julian. We're already quite aware of the decline. We're noticing that loans issued three to four months ago are now eligible for refinancing. For instance, there were some mortgages with a 3% coupon and quotes between 3 and 3.9 that are now refinanceable. Currently, we're observing mortgage rates around 3 to 3.8. If rates were to drop another 25 to 60 basis points, the market would become significantly more conducive to refinancing. On the RMBS side, while we've seen decent speeds, I could easily envision those increasing by 50%.

Mike Smyth, Analyst

That's helpful. And then just one more for me. Could you provide an inter-quarter book value update us anything as a legacy at the end of July?

Jay Lown, President and CEO

Sure. I would characterize it as down approximately 1% to 2%.

Mike Smyth, Analyst

Thank you for taking my questions.

Operator, Operator

Our next question is from Steve DeLaney from JMP Securities. Please proceed with your question.

Steve Delaney, Analyst

Hey, good evening, everyone.

Jay Lown, President and CEO

Hey, Steve. How are you?

Steve Delaney, Analyst

I’m good, Jay. Hope you are.

Jay Lown, President and CEO

Yeah.

Steve Delaney, Analyst

Overall, there's a lot to be grateful for considering everything we've experienced this year. Congratulations on that. You mentioned liquidity multiple times in your remarks. Reflecting on the Board's decision in June to lower the dividend from $0.40 to $0.27, that was a significant reduction. At that time, it seemed you had to anticipate exceeding $0.40 in core earnings. I didn't revise my projections until after that announcement, so I was lower by 25%, while the highest estimate was 32%. It feels like we might have been misled or perhaps overestimated the need for deleveraging. Was the decision primarily made to safeguard liquidity, particularly in relation to servicing advances rather than repo or other factors? Could you clarify why there was such a substantial dividend cut compared to the core earnings outcome? Thank you.

Jay Lown, President and CEO

We wanted to focus on maintaining a strong balance sheet, especially considering the uncertainties surrounding forbearance. At that time, we were just beginning to gauge how many borrowers would enter forbearance, the duration of their stay, and how it would affect our support capabilities. As a servicer, we have a responsibility to assist those borrowers, which was a key consideration. Additionally, as mentioned by one of our peers, we evaluate several metrics including core, comprehensive, taxable, and the company's true earnings power. Core income is one part of this analysis, and we anticipated that core might surpass the dividend in the short-term. However, we also needed to consider other income metrics, which influenced our decision. Furthermore, as Julian pointed out, loan speeds were high in June, and we were uncertain about their persistence. With interest rates potentially remaining low for an extended period, we expect loan speeds to stay elevated, which may negatively impact the core calculation. Our discussions with the Board focused on sustainability, emphasizing that we do not want to jeopardize the dividend.

Steve Delaney, Analyst

You don't want to miss it.

Jay Lown, President and CEO

Yeah. That's right. And so given what happened in March that was exactly true.

Steve Delaney, Analyst

So I would – yeah, go ahead. Go ahead. I'm sorry. I didn't mean to cut you off Jay.

Jay Lown, President and CEO

Could we revisit it? Sure. But we're still in the middle innings of all of this. So we do have the ability to raise it. But generically speaking or broadly speaking, I think what the Board decided was appropriate.

Steve Delaney, Analyst

Yeah. And you still have plenty of time to deal with any REIT minimum distribution requirements between now and end of the year, so that can be dealt separately.

Jay Lown, President and CEO

You'll see that in our financials. That's not an issue.

Steve Delaney, Analyst

The correlation between stocks and bonds is completely broken. It feels like we need to disregard everything we've learned from textbooks and economics. This situation seems fundamentally off. For a company focused on agency MBS and Agency MSRs, given the current circumstances, where can you turn? Paying up is the obvious choice, but those prices have increased significantly. So, if that’s the focus, what options do you have now to obtain some level of protection from speeds?

Julian Evans, Chief Investment Officer

Disney World.

Steve Delaney, Analyst

Disney? Yeah. Okay.

Julian Evans, Chief Investment Officer

I'm getting a bit more detail on the answer. I believe you can purchase securities without paying an excessive price premium on those bonds while still obtaining some protection. Although you might not hold them as long as you would prefer for higher quality products that come with a higher price premium, you can still gain some protection. On the RMBS side, we are still observing returns ranging from low to double digits, even when paying a higher price premium. Similarly, on the MSR leverage side, we continue to see low double-digit returns. We believe this combination provides an attractive return. Currently, like some of our peers, we are rolling a portion of our bonds to capitalize on the dollar roll market. This has not traditionally been a major strategy for us since we prefer to pick bonds and focus on the collateral to create collateralized stories. However, we do take advantage of specialists when the opportunity arises, and we are doing that while also selectively choosing some bonds.

Steve Delaney, Analyst

Got it.

Jay Lown, President and CEO

And I would add to that Steve that, look the Fed has indicated that they are going to continue going to continue to be involved in buying MBS. And as long as that holds true prepays and mortgage bond pricing will remain elevated. And we remain very in tune in touch with that as a determinant in how we think about deploying capital. And for those who are highly invested in lower coupon MBS today which have done well from a price perspective, the day the Fed decides that they're no longer going to support that market and size, you're going to see some meaningful hits. And so we're very in tune to that and try to maintain a balanced mortgage-backed securities portfolio relative to coupon.

Steve Delaney, Analyst

Right. Right. I'll never forget June of 2013 that Wednesday and the taper tantrum. I'm sure you guys remember that too. Listen, thanks. Thanks everyone.

Jay Lown, President and CEO

Sure.

Michael Hutchby, Chief Financial Officer

Thanks, Steve.

Operator, Operator

Our next question is from Kevin Barker with Piper Sandler. Please proceed with your question.

Kevin Barker, Analyst

So I just wanted to follow-up on the Ginnie Mae MSR sale. Could you just walk through some of the rationale behind the sale and then some of the direct impacts you may see? I'm assuming it's going to cause a significant decline in servicing costs especially with elevated forbearance that's going on right now?

Jay Lown, President and CEO

It was only a small part of our overall servicing portfolio, so the impact on the total portfolio will not be substantial. However, as you mentioned, delinquencies were rising and we weren't adding any new assets to the portfolio, making it static and deteriorating. This situation likely won't be viewed positively by regulators. Given our current perspective and short-term outlook for that sector, and considering our strategic partner is more equipped to manage recapturing refinancing, they expressed interest in the portfolio. They recognized potential in the portfolio based on recent recapture results. Together, we agreed that since we weren't planning any short-term investments in this portfolio and anticipated forbearance might increase, now might be the right time to divest. It's important not to be overly attached to any specific portfolio. We had a favorable situation allowing us to trade that asset rather than hold it for investment or maturity. From my viewpoint, it’s beneficial to engage in transactions on both sides, and since we had no plans to grow that part of the portfolio in the short term, it made sense to us. I hope this clarifies your question.

Kevin Barker, Analyst

Yes. It makes sense. Totally understandable just given the size of it and the fact that you weren't adding to it. And then also could you just talk about like some other opportunities that you may see out there, just maybe in other asset classes? And you still have healthy amount of cash and obviously you’re being conservative with it. So I’m just thinking, like, there has been quite a bit of market disruption and continues to be the case. But are you seeing any other ideas or maybe some other diversification or possibilities?

Jay Lown, President and CEO

No, that's actually a great question. Yes, right after March, a lot of us wanted to focus on strategies that align with our core. For us at that time, that meant agency MBS and servicing. What happened in credit was significant; while everyone anticipated a drop in rates, it's really credit that can pose greater challenges. Trust me, I know this firsthand. Over the last three months, we’ve concentrated on our core strengths. I do wonder about what new opportunities may arise, especially considering the market dislocations. We have fruitful discussions with the Board about where we should invest, especially relative to our core competencies. Personally, I believe we did well navigating through this. It's essential not to rush into an asset class just because it appears cheap, especially after the crisis. There are certainly asset classes within the loan space that continue to look promising to us. With the recent easing in credit, particularly in non-agency and non-QM markets, this could be worth exploring. However, I think these discussions are more suited for the fourth quarter than for the earlier quarters.

Kevin Barker, Analyst

Yes. Okay. That’s fair. I mean there’s still a lot of things that need be figured out here over the next several months or even years. Okay. And then, you guys have held up relatively well compared to your peers on book value holding up, and portfolio is fairly stable, leverage is low, cash is high. But your stock is not reflecting the strength of the balance sheet. Would you consider being a little bit more aggressive in buying back stock? Obviously, liquidity concerns there. But would you look at that? You have had a history of doing that here and there. So I was just wondering if you're looking at it just given where the stock is trading there.

Jay Lown, President and CEO

So, that's definitely a conversation we would have with the Board. And should the Board decide that that would be appropriate, I would tell you that we would act on that.

Kevin Barker, Analyst

Okay. All right. Thank you for taking my questions.

Jay Lown, President and CEO

Thanks, Kevin.

Operator, Operator

At this time, we will be conducting a question-and-answer session. Our next question is from Henry Coffey with Wedbush. Please proceed with your question.

Henry Coffey, Analyst

Yeah. Good afternoon and thanks for taking my question. In listening to the conversation that there are small pockets, it sounds like there are small pockets where you'd like to deploy capital, but there aren't any large places to put the money. Is that a fair...?

Jay Lown, President and CEO

I think that's right. Yes. I think that's right, Henry.

Henry Coffey, Analyst

And now your servicing costs, I'm just looking at my model really quickly, I mean, they're still around $6 million. Do they start to come down now that you've sold these assets? Or is this at $6.6 million that we're looking at a more likely number, for the rest of the year?

Jay Lown, President and CEO

So broadly speaking, I would say, Ginnie is the most expensive to service especially given level delinquencies and the high touch nature of the product versus conventional. So, on a pure relative basis, definitely, on an absolute basis, given the small percentage of the portfolio in that asset class, maybe not as much as you would think. But I'm happy to kind of get that out with you on the side.

Henry Coffey, Analyst

So everyone we talked to is looking at a $3 trillion mortgage market or so?

Jay Lown, President and CEO

Yeah.

Julian Evans, Chief Investment Officer

And some people brought that up in February. And the expectations for next year are pretty rich. I would forecast your...

Jay Lown, President and CEO

I would say...

Henry Coffey, Analyst

The forecast aren't there yet. But every company we talk to thinks these spills over. So that means speeds stay high, and the attraction of your two primary asset classes remains low. You can talk to the Board about buying back stock. Or just sitting here generating the kind of returns that you have, growing book value, is that the worst possible thing you could do with the next nine months?

Jay Lown, President and CEO

After what we just witnessed over the last five months? No.

Henry Coffey, Analyst

I understand that my perspective is more cautious compared to my colleagues. However, from the viewpoint of a current investor, if I were to purchase the stock today, rather than considering someone who bought it six months ago, I believe that approach of simply buying the stock and allowing it to stabilize is the most favorable strategy.

Jay Lown, President and CEO

We're focused on being proactive and determining our strategic plays. Considering the potential impact of another COVID case surge on the market and specifically on our sectors and the equity markets compared to the REIT sector, we believe there are opportunities to be aggressive, but we want to do it responsibly. We are not following the traditional agency route or going back to high leverage levels; we prefer to let others take those risks. If they succeed, that's great for them. As a hybrid REIT, we acknowledge our position and will consider smaller scale investments as opportunities arise. The past four months have been about returning to fundamental principles.

Henry Coffey, Analyst

Great. Thank you.

Jay Lown, President and CEO

Sure.

Operator, Operator

And we have reached the end of the question-and-answer session. And I will now turn the call over to, Jay Lown for closing remarks.

Jay Lown, President and CEO

Thanks so much. Everybody thank you for joining us in today's call. And we look forward to updating you soon on our third quarter results. And we hope you remain safe and healthy. Have a great night.

Operator, Operator

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