Earnings Call Transcript - CHMI Q4 2022

Operator, Operator

Thank you for standing by, and welcome to the conference call, the Cherry Hill Mortgage Investment Corporation's Fourth Quarter '22 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. As a reminder, today's call is being recorded. I would now like to turn the conference over to your host, Mr. Garrett Edson of ICR. Please go ahead.

Garrett Edson, Host, ICR

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's fourth 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 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. Welcome to our fourth quarter 2022 earnings call. Our efforts were effective in the fourth quarter to protect book value as investment markets remained in a challenging economic environment. High inflation and a well-supported U.S. employment market led the Fed to hike rates 125 basis points during the fourth quarter, and it appeared that the Fed was making headway with its efforts to lower inflation back to its target level. Volatility subsided during the quarter and spread sector assets recovered some of the losses experienced in the third quarter. As many of our peers have noted, the mortgage basis improved throughout the quarter as well. The U.S. Treasury yield curve, however, remained inverted and has shown no signs of steepening thus far this year, which has significantly impacted the earnings power of many companies in our sector. Given the most recent economic data, markets are bracing for a higher, for longer scenario and the potential for a recession later this year. The combination of our efforts to refine our investment and hedging strategies has enabled us to be successful in stabilizing and protecting book value in recent quarters. Given the expectation of continued interest rate hikes and the evolving macro environment, we remain positioned for additional rate hikes. To that point, we continue to utilize TBAs to partially offset spread widening risk as we await the Fed to convey when it expects to end its tightening cycle, at which point, we could look to increase our risk profile. For the fourth quarter, while we generated a GAAP net loss applicable to common stockholders of $1.59 per diluted share, we generated earnings available for distribution, or EAD, a non-GAAP financial measure, of $5.3 million or $0.24 per share. It bears repeating that EAD is only one of several factors considered in setting our dividend policy. Thus, while not aligned this quarter, our Board continues to monitor our earnings capabilities to ensure our dividend is at an appropriate level. Book value per common share finished at $6.06 as of December 31, up $0.01 from the prior quarter. We believe creating a more stable book value profile is in our shareholders' best interest and remains a top priority for us. When you consider that our preferred stock makes up a significant portion of our overall equity profile, we were pleased that on an NAV basis and before taking into account any issuances of equity through our common stock ATM program, we posted a stable NAV relative to the third quarter. As such, during the second half of 2022, NAV was off approximately 5.1%, which we believe compares favorably to the performance of many others in our industry and speaks well to our ability to navigate a very challenging macro environment and the unprecedented speed of Fed rate hikes. During the fourth quarter, we acquired approximately $780 million in UPB, Fannie and Freddie MSRs via flow and bulk purchases. Prepayment speeds on our MSR portfolio remained low. And thus, the pace of reinvestment to maintain the allocation of capital to the asset class has decelerated. Recapture rates on MSRs also slowed to the low single digits as expected given the higher interest rate levels. Our strategy of pairing MSRs with agency RMBS along with proactive portfolio management and hedging has continued to benefit shareholders. At the end of the year, financial leverage improved modestly to 3.8 times as we took a more targeted and disciplined approach in the fourth quarter with respect to deploying capital. Given the ongoing market volatility, we believe we remain prudently levered and expect to be opportunistic in deploying capital and increasing our leverage in 2023. We ended the year with $57 million in unrestricted cash on the balance sheet, maintaining a solid liquidity profile. As we look forward in 2023, we expect to maintain our conservative and proactive approach to portfolio management. Where there are risk-adjusted opportunities to selectively deploy capital, we will take advantage. Additionally, we anticipate our hedge ratio will likely remain elevated given our expectations of ongoing Fed rate hikes to further combat stubborn inflation. Our priority remains to protect book value and we will remain mindful of our liquidity and leverage profile given the environment. With that, I'll turn the call over to Julian, who will cover more details regarding our investment portfolio and its performance over the fourth quarter.

Julian Evans, Chief Investment Officer

Thank you, Jay. Investment themes that were prominent in the third quarter rolled over into the fourth quarter. Heightened volatility, thinly liquid investment markets, widening spread sectors, and weakening equity markets were all influenced by a Fed determined to reduce inflation. All changed after the October and November CPI reports, as the reported inflationary numbers suggested that inflation was moderating faster than expected. Post the inflationary numbers, spread sector and equity markets tightened and interest rate markets firmed as investor sentiment changed. The sentiment change was driven by our perception that the Fed might end up doing fewer Fed fund rate increases than were initially expected. With that said, most inflationary measures have moderated but remained elevated above the Fed's 2% target for the first two months of 2023. Stubbornly high inflation has led to renewed predictions of the Fed having to increase the Fed's funds rate greater than what the market had initially perceived. The market is currently expecting a terminal Fed's fund rate level between 5.25% and 5.75%. As a result, we continue to employ a thoughtful hedging strategy in the fourth quarter to protect our book value and we believe those efforts have largely been working as intended. This investment strategy has carried over into the first quarter of 2023. At year-end, our MSR portfolio had a UPB of $21.7 billion and a market value of approximately $280 million. During the quarter, we purchased approximately $780 million UPB of new MSRs through our bulk and flow programs. At year-end, the MSRs and related assets represented approximately 38% of our equity capital and approximately 30% of our investable assets, excluding cash. Meanwhile, our RMBS portfolio accounted for approximately 45% of our equity capital. As a percentage of investable assets, the RMBS portfolio represented approximately 70%, excluding cash, at year-end. During the quarter, we continued to experience CPR improvements in both our MSR and RMBS portfolios. Our MSR portfolio's net CPR averaged approximately 5% for the fourth quarter, down from approximately 7% net CPR in the previous quarter. The decline was mainly driven by seasonality and the change in mortgage production coupons, which drove slower prepayment speeds in the quarter. The portfolio's recapture rate was lower at approximately 2% versus approximately 7% in the third quarter. As expected with mortgage rates rising, the incentive to refinance has lessened. Moving forward, we continue to expect low recapture rates and stable or improved net CPRs for the foreseeable future, given the current levels of interest in mortgage rates. The RMBS prepayment speeds remain low. The lower CPR was driven by a combination of new asset purchases as well as the fact that the current higher mortgage rate environment is compressing CPRs for the existing portfolio. As of today, the majority of the mortgage universe remains out of the money in terms of refinancing. We would expect prepayments to remain at low levels as long as interest rates stay at these levels or move higher. For the quarter, the RMBS portfolio's weighted average three-month CPR reduced to approximately 3.8% compared to approximately 4.7% in the third quarter. As of December 31, the RMBS portfolio, inclusive of TBAs, stood at approximately $646 million compared to $759 million at the previous quarter end. Quarter-over-quarter, the spec pool portion of the portfolio continued to grow as we opportunistically took advantage of higher interest rate levels and lower price premiums by putting new cash to work, as well as converting a few dollar rolls into pools as dollar rolls weaken further. The RMBS portfolio number is lower as we further utilized TBA securities to hedge a portion of the portfolio. We also continue to proactively change the portfolio's composition, moving into higher coupons and reducing spread duration for the portfolio. At the end of the fourth quarter, the 30-year securities position represented the entire RMBS portfolio, up from 96% at the end of the third quarter. For the fourth quarter, we saw an increase in RMBS net interest spread to 3.77% as compared to 3.49% net interest spread reported for the third quarter. The improved NIM was driven by previously mentioned factors. One, we took advantage of wider mortgage spreads and higher yield levels by putting new money to work throughout the quarter. Two, we rotated our portfolio swapping out of low yielding assets and purchasing higher coupon mortgages with better yields. Overall, expenses were greater, but were more than offset by increased income, which was driven by the previously mentioned reasons. At year-end, the portfolio's financial leverage stood at approximately 3.8 times at the aggregate portfolio and the portfolio was managed with a negative duration gap. Looking forward, we remain mindful of the current environment as we expect the investment markets to remain choppy until there is a clear sense that the Fed is reaching its terminal rate.

Michael Hutchby, Chief Financial Officer

Thank you, Julian. Our GAAP net loss applicable to common stockholders for the fourth quarter was $34.5 million or $1.59 per weighted average diluted 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 $6.2 million or $0.29 per weighted average diluted share. Our earnings available for distribution attributable to common stockholders were $5.3 million or $0.24 per share. Our book value per common share as of December 31, 2022 was $6.06 compared to a book value of $6.05 as of September 30, 2022. 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 fourth quarter, we held interest rate swaps, TBAs, treasury futures and options on treasury futures, all of which had a combined notional amount of $930 million. You can see more details with respect to our hedging strategy in our 10-K as well as in our fourth 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 $3.2 million for the quarter. On December 15, 2022, the Board of Directors declared a dividend of $0.27 per common share for the fourth quarter of 2022, which was paid in cash on January 31, 2023. 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 January 17, 2023. At this time, we will open up the call for questions.

Operator, Operator

Thank you. Our first question comes from the line of Mikhail Goberman of JMP Securities. Your line is open.

Mikhail Goberman, Analyst

Hey, good afternoon, gentlemen. Thanks for taking the question. Could you perhaps expand a little bit further on the comment about the viability of the dividend versus what sort of a sustainable level of core earnings you might see going forward given the especially given Powell's comments today about where rates are headed? And also, I don't know if I heard you guys correctly, but did you say that book value was down 5% thus far this quarter?

Jay Lown, President and CEO

Hey, Mikhail, how are you? So, the answer to your second question is, no, we didn't say that at all. Book value till the end of February prior to the dividend is flat.

Michael Hutchby, Chief Financial Officer

That's right.

Mikhail Goberman, Analyst

Okay. Thank you. Apologies for that.

Jay Lown, President and CEO

No worries. With respect to the dividend, look, I think you've heard from us before and you'll continue to hear that we consider EAD as a measure. And I think we alluded to that in the script, but we look at total return. We obviously think about where rates may go and how sustainable the dividend is over time. And broadly speaking, the Board meets every quarter and we'll continue to evaluate the strength of the dividend relative to earnings power and the requirements of the market relative to our space. And we expect to provide more information on that later this week.

Mikhail Goberman, Analyst

All right. Thank you. And just going forward, how do you guys think about the trade-off between building the portfolio towards agency RMBS and MSRs? If interest rates do keep sort of breaking through the 5.25% to 5.75% expected rate, if we start going into a 6% handle, how do you start thinking about your portfolio then? Thanks.

Julian Evans, Chief Investment Officer

Hi, Mikhail. Look, I think the early read is that we have preferred our agency RMBS at these particular levels, which we would say is kind of in the mid-teens that we kind of see the returns. We have also aiding, I think, some of the performance. We have a rather large swap portfolio, which has kind of moved, coincided with repo rates rising almost on a one-to-one basis for us. So that has offset some of the rising repo costs that we've seen. So, if the Fed is moving higher, that portfolio has benefited us. In terms of MSR and the kind of the returns that we're seeing right now in terms of the portfolio, I would say kind of low to mid-teens is kind of what we're seeing for those type of returns. But in general, we're evaluating that constantly over time. But I would say just from a spread widening perspective, agency RMBS looks rather attractive.

Mikhail Goberman, Analyst

All right. Thank you, gentlemen. Appreciate it. Good luck going forward.

Jay Lown, President and CEO

Thanks, Mikhail.

Operator, Operator

Thank you. One moment please. Our next question comes from the line of Mr. Howlett of B. Riley. Your line is open.

Matthew Howlett, Analyst

Hello. Hey, guys. Hey, Jay. Thanks for taking my question.

Jay Lown, President and CEO

Hi, Matt.

Matthew Howlett, Analyst

I would like to hear from the team about how you see the company's risk profile today. Clearly, leverage is low compared to historical levels and decreased in the fourth quarter. When I review your sensitivities regarding interest rates, it seems the book doesn't change significantly, and you're currently overhedged. How would you describe the current situation? Also, without asking something too obvious, what would it take to start increasing leverage to capitalize on these undervalued MBS assets? I would appreciate your insights regarding the company's current position compared to its historical performance.

Julian Evans, Chief Investment Officer

It's Julian again. I believe we are in a position where the market appears very appealing, but clearer guidance from the Fed is necessary. Powell made comments today suggesting that interest rates and Fed funds rates may rise. Currently, the market anticipates rates to be around 5.25%, roughly between 5.25% and 5.75%. If we consider the situation a month ago, prior to the improved data from January, the market likely expected the Fed to halt around 5% to 5.25% at that time. I think if we receive clearer direction from the Fed regarding their rate plans, that will present an opportunity to increase leverage and take better advantage of the market.

Matthew Howlett, Analyst

And then, regarding the Fed's actions with the balance sheet, what are your thoughts on their MBS holdings?

Julian Evans, Chief Investment Officer

I think the initial reception is that basically that the Fed would not sell MBS. They've had multiple opportunities to kind of sell MBS throughout this time period that they've been actually raising the Fed funds rate. I think that's their most effective tool at least from their perception is that they'd like to continue to raise the Fed funds rate to levels they perceive that will kind of slow down the economy and retain the balance sheet. Can allude to that at some point if continuing to raise, the Fed's funds rate proves to be ineffective that they might try to do something on the balance sheet. It's a possibility, but it wouldn't be, in my mind, a high percentage of that's what they would like to do.

Matthew Howlett, Analyst

Got it. That makes a lot of sense. Moving on to servicing, it has been a valuable asset and an effective strategy for you. Considering the current MSR values and the low coupon and underlying coupon in servicing, if there is a scenario where some forecasts predict the Fed might cut rates later this year or early next year, would you consider reallocating more MBS? Should servicing continue to run its course, do you believe that profile, along with your recapture, will remain a core asset if the interest rate cycle changes? I'm interested in your perspective on servicing this year.

Jay Lown, President and CEO

Yes, sure, Matt. So, the portfolio has a note rate of, let's just call, 3.5%. And the current interest rate on mortgages is, let's just round it, 6.5%. So, from the perspective of that portfolio, the way we look at that portfolio is there's a lot of runway in terms of having pretty strong cash flows before that portfolio is in danger of refinancing outside of normal life events. And so, we really feel good about the strength of the cash flows in that portfolio despite the rates at this point given the duration and the complexity of that portfolio, which is almost non-existent at this point. We think there is a lot of room to run on that portfolio should the Fed cut rates at some point in time before we have to even start thinking about recapture and things around the degradation of that portfolio. So, we feel really good about the profile of that portfolio today, because the reality is, speeds are your enemy. You can hedge a lot of things rate-wise, but speeds are your worst enemy. And from our vantage point, given the acquired characteristics that are inherent in the portfolio today, we think that asset is going to continue to perform pretty strong.

Matthew Howlett, Analyst

Yes. The speeds have reached levels I've never seen in my lifetime. I am unsure how much lower they can go, but it's remarkable to witness such a significant decline. I know you are protected from prepayment on the MBS side, but I'm curious about the servicing. With strong cash flows, would you be looking to be more active in the bulk market with some of these smaller originators that are selling or going out of business? It seems like the value has decreased a bit earlier this year. Would you consider growing that portfolio, given that there appear to be many sellers, including some large ones?

Jay Lown, President and CEO

So, we look at portfolios every day. And for the smaller originators, it's our expectation that there is a concession in price, which is favorable to us in terms of yield. And so, we absolutely look and see a lot of those portfolios on a regular basis. If you're asking me if we're seeing a lot of small guys sell, I wouldn't say we're seeing a lot of small guys sell. We're seeing a decent steady flow of volume away from what I would call the wells dynamic going on today. But there is an opportunity to acquire the asset at levels that, I would say, were slightly lower than the craziness in the fourth quarter.

Matthew Howlett, Analyst

Yes. Right. Exactly. That's exactly where I was going, there might be an opportunity for you guys. Well, look, I'll just say that the performance has been terrific, I mean, the yield curve is inverted and you guys are generating this positive economic return that looks just terrific, and really congratulate on really some great results and hopefully a very strong 2023. Thanks a lot.

Jay Lown, President and CEO

Thanks, Matt.

Operator, Operator

Thank you. I'm showing no questions at this time. I'd like to turn the call back over to management for any closing remarks.

Jay Lown, President and CEO

Thank you, operator. Thank you everybody for joining us on our fourth quarter 2022 earnings call. We look forward to updating you on our first quarter results sometime in May. Have a good evening.

Operator, Operator

Thank you. Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.