Earnings Call Transcript - CHMI Q2 2022

Operator, Operator

Thank you for standing by. My name is Cheryl, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cherry Hill Mortgage Investment Corporation Second Quarter 2022 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you. Garrett Edson, you may begin your conference.

Garrett Edson, IR Representative

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's second quarter 2022 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. 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 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 entire mortgage REIT sector was impacted by numerous macro and geopolitical concerns in the second quarter. In addition, the Fed turned aggressively hawkish to combat inflation as anticipated and hiked rates twice during the quarter, 50 basis points in May and 75 basis points in June. Last week, we navigated yet another 75 basis point hike. We continue to believe the Fed will remain aggressive with respect to tightening monetary policy in the near term, given their focus on bringing inflation down towards their target levels. In response, the US 10-year treasury rose to 3.5% by mid-June, and we were positioned well for the higher rate environment. However, recession fears gripped markets towards the end of June, leading to a rally in rates that continued through July. This, coupled with mortgage spreads widening during the quarter, most meaningfully at the end of June, negatively impacted our book value for the quarter. Ultimately, the US 10-year treasury finished the quarter at 3.02%, 68 basis points above its closing level at March 31. Our portfolio strategy has remained intact, pairing MSR with Agency MBS. We are constructive on agency mortgage spreads, given the significant widening this year and believe our positioning there has had a positive impact on performance year-to-date. We continue to actively adjust our investment portfolio to protect the business and remain less levered relative to historic norms in this dynamic macro environment to preserve book value. Julian will provide more details on our efforts shortly. For the quarter, improving prepayment speeds continue to aid our earnings available for distribution, or EAD, a non-GAAP financial measure. For the second quarter, we generated a GAAP net loss applicable to common stockholders of $17.6 million or $0.92 per diluted share, and we generated EAD of $5.2 million or $0.28 per share, exceeding our quarterly common dividend level of $0.27 per share. On an annualized basis, our dividend yield is hovering in the mid-teens based on the recent average of our closing price of our common stock. Importantly, EAD is just one of several factors we consider in setting our dividend policy. Book value per common share finished at $6.73 as of June 30. 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 in common or preferred equity, our performance in the quarter was more effective with NAV down approximately 4% quarter-over-quarter before taking into account any common stock issuances pursuant to our ATM program. We believe our NAV performance demonstrates that the actions we took during the first half of the year, along with our strategy of pairing RMBS with agency MSRs, contributed to mitigating risk and moderating the full impact of spread widening in Agency RMBS. That said, we remain committed to stabilizing and growing our NAV and book value as we move ahead. We continue to believe the best approach to adding to our MSR portfolio is remaining selective given the macro environment, the competition, and robust pricing. During the second quarter, we acquired approximately $950 million UPB in MSRs by a flow in both purchases. As we’ve said before, we continue to believe the strategy of marrying MSR with Agency MBS 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 3.4 times, and lower than the prior quarter as we remain mindful of the heightened market volatility in our current environment. We ended the quarter with $62 million of unrestricted cash on the balance sheet, maintaining a solid liquidity profile. Our recapture efforts remain solid with a 12.1% recapture rate on our MSRs in the quarter despite the rise in mortgage rates. That said, recapture rates should continue to decline at these higher levels. Though prepayment speeds, net of recapture should continue to remain low. Looking ahead, we will continue to closely monitor MBS spreads, and at the appropriate time, we will look to raise our leverage toward more normalized levels. Our proactive decision to derisk the portfolio and sell securities helped mitigate the impacts of the rising rates and spread widening during the first half of 2022. We remain positioned for a bias towards further Fed tightening of monetary policy and a high rate environment for the foreseeable future as the economy tackles the highest inflation it has seen in over 40 years. In the meantime, we are keeping a firm on our balance sheet. And when we see attractive investment opportunities, we will continue to selectively invest. With that, I will 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. As Jay noted, the second quarter was marked by a rapid rise in interest rates as the Fed worked to combat escalating inflation levels, including executing the first 75 basis point hike in nearly 30 years. The quarter also marked the start of the Fed outlining a plan and working to reduce its balance sheet. Throughout the quarter, we positioned our portfolio for a rising rate environment as the US tenure rate rose to nearly 3.5 by the middle of June. Just as quickly, US tenure fell in the final two weeks of the quarter and continued to move lower in July, despite the Fed hiking defense funds rate another 75 basis points for a second consecutive month. The market continues to attempt to outpace the Fed. And for now, it seems to believe 3.5 is the ceiling for Fed funds, but until inflation appears to moderate, the Fed will likely need to continue hiking rates, which may lead to a hard landing as the Fed tries to precariously balance curbing inflation without sinking the economy. At quarter end, our MSR portfolio had a UPB of $21 billion approximately and a market value of approximately $264 million. During the quarter, we purchased approximately $950 million UPB of new MSRs through our bulk and flow programs. At the end of the second quarter, the MSR portfolio represented approximately 40% of our equity capital and approximately 24% 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 76% excluding cash at quarter end. During the quarter, we continued to experience CPR improvements in both our MSR and RMBS portfolios. Our MSR portfolio's net average CPR was approximately 10% for the second quarter, down from approximately 13% net CPR in the previous quarter. The decline was mainly driven by the continued rapid rise in interest rates and the change in mortgage production coupons, which drove slower prepayment speeds in the quarter. The portfolio's recapture rate was lower at 12% versus 20% in the first quarter, which is expected as interest rates rose, making the incentive to refinance less attractive. Going forward, we should continue to expect a lower recapture rate, but stable or improving net CPRs given the elevated levels of interest rates and mortgage rates. The RMBS portfolio's prepayment speeds exhibited similar trends, with the portfolio's weighted average three-month CPR reducing to approximately 7% for the second quarter compared to approximately 11% in the first quarter. As rates move higher, mortgage securities became less refinanceable. As of today, the majority of the mortgage universe is out of the money in terms of refinancing. We would expect repayments to remain low as long as rates stay at these levels or move higher. As of June 30, the RMBS portfolio inclusive of TBA stood at approximately $831 million, compared to $941 million at the previous quarter end. The portfolio 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 to protect book value as interest rates rose. In addition to reducing the size of the RMBS portfolio, we changed the portfolio's composition, moving into higher coupons and reducing spread duration for the portfolio. In addition, we took the opportunity to improve yields for the portfolio in the quarter. At the end of the second quarter, the 30-year securities position represented 93% of our RMBS portfolio, a similar percentage to the end of the first quarter. Shorter duration securities made up 7% of the portfolio at quarter end. For the second quarter, we posted a 3.46% RMBS net interest spread versus a 3.06% net interest spread reported for the first quarter, driven by higher yields as we repositioned the portfolio, coupled with the combination of better prepayment speeds. The spread was also aided by lower net interest expenses due to our payer swaps at three-month LIBOR and SOFR reset to higher loans, which minimized the effects of higher repo costs. At quarter end, the portfolio leverage stood approximately 3.4 times at the aggregate level, and the portfolio was managed with a negative duration gap. Looking forward, we remain cautious, and we expect the investment markets to remain volatile and operate with limited liquidity. The Fed verbally remains committed to bringing inflation down from a 40-year high. Last week, the Fed raised the Fed funds rate, and we expect them to raise the Fed funds rate further in fiscal year 2022. Despite its efforts, inflation remains at elevated levels. Over the next several weeks, the battle in the markets will weigh between the Fed's commitment to inflation fighting and an economic slowdown or possible recession. Current markets are implying that the Fed will be able to handle inflation which would give way to a pending recession in 2023 and start the process of easing monetary policy. The investment markets are attempting to front run, anticipating a Fed pivot by assuming the Fed will either moderate the size or the pace of the Fed funds increases as well as never reach the upper side of its range. We expect the economy to slow, but the Fed remains committed to lowering inflation as inflation remains solidly above its target of 2%. I will 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 $17.6 million or $0.92 per weighted average diluted share outstanding during the quarter. The comprehensive loss attributable to common stockholders, which includes the mark-to-market of our held-for-sale RMBS, was $5 million or $0.26 per weighted average diluted share. Our earnings available for distribution attributable to common stockholders were $5.2 million or $0.28 per share. Our book value per common share as of June 30 was $6.73 compared to a book value of $7.27 as of March 31. 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, TBAs, and treasury futures, all of which had a combined notional amount of $1.3 billion. You can see more details with respect to our hedging strategy in our 10-Q as well in our second quarter presentation. For GAAP purposes, we've 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 $3.1 million for the quarter. On June 17, 2022, our Board of Directors declared a dividend of $0.27 per common share for the second quarter of 2022, which was paid in cash on July 26, 2022. 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 15, 2022. At this time, we will open up the call for questions.

Operator, Operator

Your first question is from Henry Coffey of Wedbush. Please go ahead. Your line is open.

Henry Coffey, Analyst

Good afternoon and thank you for taking my question. How do market conditions today compare to where they were at the end of June, when we saw all these marks? Have things calmed down a bit, have spreads narrowed, or are they widening? What is the overall comparison today to June 30?

Julian Evans, Chief Investment Officer

Hi Henry, this is Julian. Regarding mortgage spreads, they have changed a bit over the past few days since the end of June. If we look from the end of June, they have tightened fairly well, perhaps between 15 to 20 basis points by the end of July. After July, the spreads have been fluctuating. For instance, they were wider yesterday but are tighter today, so we can say it's relatively stable at the start of August. But from a net perspective, go ahead.

Henry Coffey, Analyst

I'm sorry, I’m sorry, keep going.

Julian Evans, Chief Investment Officer

Well, from a spread perspective, RMBS is tighter from the end of June.

Henry Coffey, Analyst

So should we expect to see positive fair value marks coming through or more of what we've seen in the last two quarters?

Jay Lown, President and CEO

Are you talking about company-wide, Henry, or are you just talking about RMBS?

Henry Coffey, Analyst

Both, both. I mean, obviously, we've had a couple of other REITs report, so we understand what's going on.

Jay Lown, President and CEO

Yeah, sure. Mike, do you want to give Henry an update?

Michael Hutchby, Chief Financial Officer

Through July 31, we see book value per share up about 2%. This figure does not include any accrual for a dividend since the board has not yet convened to approve a dividend for the quarter.

Henry Coffey, Analyst

All right. Thank you.

Operator, Operator

Your next question is from Mikhail Goberman of JMP Securities. Please go ahead. Your line is open.

Mikhail Goberman, Analyst

Hi. Good afternoon, gentlemen. Hope everybody is well. Quick 2-parter from me. Could you guys talk maybe for a little bit about how you see the Agency RMBS versus MSR pair-off trade working from a capital allocation standpoint going forward? And also, is there any appetite to maybe tick up leverage from this point on? Thanks.

Jay Lown, President and CEO

Sure. To the first question, which I think was how do we think about the allocation of capital relative to the percentage of equity to each strategy. I think one of the things that we've done, as you know, we've taken down leverage on the RMBS side throughout the year, just given our view on where spreads could go and some of the volatility in the space as rates backed up, what I would call meaningfully through the quarter. During that process, speeds for the MSR portfolio have remained low. So the desire to grow that portfolio versus maintain the size, I would tell you that we have chosen to more maintain the size of the portfolio and the percentage of equity in each asset class. I think, primarily one, because of the MSR market being a little bit on the rich side today, relative to where we think the value is in terms of the newer production. And our view that we think that spreads should normalize on the RMBS side, and we would look to increase our activities on that side of the house.

Mikhail Goberman, Analyst

Got it. Thanks for that.

Jay Lown, President and CEO

As it relates to the leverage question, I think we have a view that spreads are starting to normalize. I think you've heard other people say the same, and we've seen some people raise capital with the intention of deploying capital into the agency space. We are constructive on the RMBS space today. We think that there's value there. But we are very mindful of the volatility day-to-day in the market, relative to all things geopolitical, macroeconomic, and anything related to what the Fed may or may not say on any given day.

Mikhail Goberman, Analyst

Thanks, Jay.

Operator, Operator

Your next question is from Matthew Howlett of B. Riley. Please go ahead. Your line is open.

Matthew Howlett, Analyst

Hey, Jay. Thanks for taking my question.

Jay Lown, President and CEO

Hi, Matt.

Matthew Howlett, Analyst

In terms of MSR valuation, can MSR values continue to rise, or are they likely to only move in one direction from this point? Additionally, when services discuss escrows, I assume you receive the escrows on the MSRs. Will this have an impact if federal funds continue to increase?

Jay Lown, President and CEO

I'll address the second part of your question first. Escrows are indeed a factor in the overall valuation, and as interest rates increase, they play a more significant role. We're very attentive to this when considering the overall MSR valuation. Essentially, as rates rise, escrows become a more substantial piece of the valuation of the asset class compared to lower rates. The first part of your question is a bit more complex as it depends on the composition of the collateral in the portfolio. If the portfolio consists mainly of lower coupon MSRs, we've observed that as rates increase, the benefits and correlation with assets stabilize and tend to become less correlated. However, when more MSRs with current coupons are added, those assets can experience greater fluctuations due to being more in the money. Does that address your question? Currently, our portfolio has a barbell structure, with part at around 3.25% and below and another part at 3.75% and above. There isn't much value for us in the range between 3.25% and 3.75%. Therefore, there's potential for growth in the portfolio's value, but not significantly in the lower coupon segment.

Matthew Howlett, Analyst

Got you. That's really helpful. I heard your comments about the market still being volatile and your desire to keep some reserves. I didn't catch your thoughts about the Fed. Do you think the Fed will begin selling MBS? It's taken a while to start the process. How significant do you believe that impact will be? Are you waiting for a wider spread if they do start selling?

Jay Lown, President and CEO

That's a great question. Overall, I believe our performance this quarter surpassed many agency players. This was partly because we sold off a significant portion of the lower coupon mortgage-backed securities earlier in the quarter, anticipating a possible widening of spreads in that segment. Others may have held onto their investments and felt the impact in the second quarter, benefiting more in the third quarter. We strategically moved away from the lower coupon segment due to concerns that if the Fed starts to sell, as the main holder, they could significantly affect spreads there. While we don't have a strong opinion on whether they will sell or just let it run off, we chose not to take that risk. This decision contributed to a more stable profile in terms of book value on that side, wouldn't you agree, Julian?

Julian Evans, Chief Investment Officer

Yeah, I think so.

Matthew Howlett, Analyst

No, that makes sense; it's definitely smart repositioning. The book performed significantly better than its peers. I believe the final point is that Cherry Hill took this approach largely because they have a bit more preferred, and there’s a need to recover this base in the book. You mentioned that with 50 basis points of tightening, the book could potentially return to $8 or $9. However, on the other hand, you probably prefer the wide spreads and wouldn't want to see the basis tighten. So investors should consider focusing on achieving high returns and cash flows with low leverage, rather than simply waiting for spreads to tighten. Do you believe this is an opportune moment to start growing again, given the current spread environment and your favorable position?

Jay Lown, President and CEO

I would say we are currently experiencing a significant widening in coupon spreads. It's not straightforward to generalize this due to the varying ownership of certain coupons and our perspective on what the historical norm for these spreads should be. However, we do anticipate increasing our leverage at some point. We feel positive about the reductions we've made so far and are seeking favorable opportunities to expand the RMBS portfolio as we believe conditions will return to a more historically normal state. Julian, do you have anything to add?

Julian Evans, Chief Investment Officer

Yes, I believe the key concern is the need for stability in rates. Recently, we've experienced fluctuations of about half a point to a full point daily, which translates to six to twelve basis points. We are seeking some stability, which hasn't fully materialized in the markets yet. In the latter part of the third quarter, lower coupon mortgages have performed better due to the flattening and continued inversions of the yield curve, while higher coupons have lagged in spread tightening. Overall, if we can achieve more stability, we can increase our leverage and invest more effectively. However, we need to see more consistency from the Federal Reserve. This week, the Fed reaffirmed its commitment to raising interest rates to a more restrictive level for the economy. This all ties back to the ongoing debate we will face in the coming months regarding a potential recession or a soft landing, and whether the Fed can accomplish its goals regarding the federal funds rate.

Matthew Howlett, Analyst

Got you. Well, look, I mean, returns are just phenomenal for the leverage commonly using. So, to think that they could get better is something that's really open. But I appreciate the patience and thanks for your comments.

Jay Lown, President and CEO

Thanks, Matt.

Operator, Operator

We have completed the allotted time for questions. I will now turn the call over to Jay Lown for closing remarks.

Jay Lown, President and CEO

Thanks, everyone, for joining us on our second quarter 2022 call, and we look forward to updating you in a couple of months for our third quarter results. Have a great evening.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.