Mfa Financial, Inc. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to the MFA Financial, Inc. Second Quarter Earnings Conference Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Hal Schwartz. Please go ahead.

Thank you, operator. Good morning, everyone. The information discussed on this conference call today may contain or refer to forward-looking statements regarding MFA Financial, Inc. which reflect management's beliefs, expectations and assumptions as to MFA's future performance and operations. When used, statements that are not historical in nature, including those containing words such as will, believe, expect, anticipate, estimate, should, could, would or similar expressions are intended to identify forward-looking statements. All forward-looking statements speak only as of the date on which they are made. These types of statements are subject to various known and unknown risks, uncertainties, assumptions and other factors, including those described in MFA's annual report on Form 10-K for the year ended December 31, 2019, and other reports that it may file from time to time with the Securities and Exchange Commission. These risks, uncertainties and other factors could cause MFA's actual results to differ materially from those projected, expressed or implied in any forward-looking statements it makes. For additional information regarding MFA's use of forward-looking statements, please see the relevant disclosure in the press release announcing MFA's second quarter 2020 financial results. Thank you for your time. I would now like to turn this call over to MFA's CEO and President, Craig Knutson.

Thank you, Hal. Good morning, everyone. I'd like to thank you for your interest in and welcome you to MFA Financial's Second Quarter 2020 Financial Results Webcast. Also dialed in with me today are Steve Yarad, our CFO; Gudmundur Kristjansson; and Bryan Wulfsohn, our Co-Chief Investment Officers; and other members of senior management. Before we begin, I'd like to give a shout-out to our entire MFA team. The last five months have obviously been extremely challenging and made exponentially more so by the fact that all of our efforts have been remote as the company fully implemented our business continuity plan during the third week of March. The effort and commitment put forth by our entire team over the last five months has been extraordinary, and I have been awed by their dedication. Although the bottom-line earnings per share results for the second quarter of 2020 might, at first glance, appear to be a return to normal for MFA, the second quarter was anything but normal. After a COVID-19-induced mortgage market meltdown that began in mid-March, we were in the middle of negotiating a forbearance agreement with our significant lenders as the second quarter began. These negotiations resulted in our first forbearance agreement, which took effect 10 days into the quarter on April 10, although our lenders who were party to this agreement had essentially been granting us forbearance since March 23. Forbearance agreements were extended on April 27 and again on June 1, and we exited forbearance on June 26, so we spent nearly the entire second quarter under forbearance. While these forbearance agreements were expensive and required a massive effort to manage, they afforded us the time necessary to delever our balance sheet, generate liquidity and conduct a thorough and competitive process to source third-party capital. Our second quarter financial results were overwhelmingly dominated by unusual events and transactions. Sales of residential mortgage-backed securities in the second quarter generated $177.5 million of net realized gains versus their March 31 marks. The sale of a large Non-QM whole loan pool generated a loss of $127.2 million; however, $70.2 million of this loss was booked as an impairment in the first quarter in anticipation of this sale, making the second quarter recognized loss $57 million. We booked a $49.9 million loss related to swap hedges that were terminated during the first quarter. High forbearance interest expense and $14.2 million of amortized swap losses generated very high interest expense of $82.1 million for the period that resulted in no net interest income for the quarter. We also recorded $40 million of expenses related to forbearance and portfolio restructuring. Although we earned $0.19 per share in the second quarter, this was the result of many large and unusual items. GAAP book value was up primarily due to GAAP earnings that were not paid out in dividends. Economic book value was up additionally as we saw continued price improvement in our carrying value whole loans. We elected the fair value option to account for all new and reinstated financing. This allows us to expense upfront fees and other costs associated with these transactions, allowing us to present a more true economic go-forward cost of these financing arrangements. Our leverage ratio at June 30 was 2:1. Our investment mortgage assets consisted of $5.9 billion of residential whole loans and approximately $400 million of mortgage-backed securities. As previously announced, we closed our capital transaction with Apollo and Athene on June 26. This transaction included a $500 million senior secured term loan, a warrant package to purchase 7.5% of MFA common stock, over $2 billion of new non-mark-to-market financing provided by Apollo and Athene, together with Barclays and Credit Suisse. Additionally, Apollo and Athene have committed to purchase the lesser of 4.9% or $50 million of MFA common stock in the open market over the next year. Athene has also committed to purchase a portion of MFA's first Non-QM securitization. I cannot stress enough that this transaction was about a lot more than a $500 million check; it is very much a holistic solution and a strategic and collaborative partnership. With the pause afforded to us through forbearance and assistance from Apollo and Athene, we have also been able to profoundly restructure our liabilities to a much more durable form of financing. Of the $4.7 billion of borrowing that is asset-based or secured, $3 billion is non-mark-to-market and two-year term, and another $785 million is intentionally underlevered by approximately $55 million, thus creating a margin cushion of approximately six points. Additionally, we have $330 million of unsecured debt with our senior note and convertible bond. All told, over 80% of our borrowing is either non-mark-to-market or under levered. The cost of the aggregate secured financing away from the Apollo, Athene senior loan and our existing securitized debt is approximately 3.6%. Replacing some of this borrowing with securitization, particularly for Non-QM loans at current new issue levels could lower this cost by about 100 basis points depending on how deep in the capital stack we sell. As previously mentioned, we exited forbearance on June 26, with substantial liquidity, no outstanding margin calls and all lenders repaid in full. Although an expensive and time-consuming process, we believe that we were able to protect hundreds of millions of dollars of book value by liquidating assets in an orderly and negotiated fashion rather than through a fire sale liquidation during the last two weeks of March. Additionally, we conducted a robust and competitive third-party capital process, which led to a much better transaction than we could have achieved in a compressed and rushed timeframe. While MFA is admittedly a smaller company than we were in February, we believe that we are on very solid footing during what remains a very uncertain economic environment. Not only do we have very durable financing, but we also have substantial liquidity. The securitization market continues to improve amidst dwindling supply, offering us the ability to realize considerable cost savings. Furthermore, we have reinstated the payment of all accumulated but unpaid dividends on our Series B and Series C preferred stock issues, and we have declared a common stock dividend of $0.05 per share payable on October 30, 2020, to stockholders of record on September 30. As most of you know, as a REIT, we are required to pay 90% of our taxable income in the form of dividends, and those dividends can be both on preferred stock and common stock. To the extent that we pay 90% or more, but less than 100% of our taxable income, we are required to pay income taxes on the amount by which our dividend distributions fall short of 100% of our taxable income. Finally, we generally have until October of the year following the tax year to make these distributions. We are required to pay an excise tax to the extent that we do not declare at least 85% of the required distribution during the current year. The excise tax is paid on the amount of shortfall below the 85%. Preferred dividends for the year at the contractual dividend rate will total $29.8 million or about $0.065 per common share. The preferred dividends will satisfy the distribution requirement on the $0.05 of 2019 taxable income with approximately $0.085 to apply to taxable 2020 income. With an estimated $0.14 of taxable income through June 30, the 85% distribution required to avoid the excise tax is about $0.12 or $0.105 after the preferred dividends. Pages 10 and 11 present pie charts to illustrate how our portfolio composition and our secured liability structure changed during the second quarter. Our investment portfolio is lower by one-third and is now comprised of 94% whole loans, up from 74% at March 31, and our secured liabilities are lower by 43% and are nearly two-thirds non-mark-to-market versus nearly 100% mark-to-market at March 31.

Thank you, Craig. Turning to Page 12. The pandemic has had a material impact on the origination of Non-QM loans. Production basically ground to a halt coming into the second quarter, but has been gradually increasing with the stabilization of the securitization market and markets more generally. Underwriting standards have tightened a bit on new production, but given that standards were already conservative pre-COVID, the change hasn't been dramatic. As part of our deleveraging process to rightsize the balance sheet, we executed on a sale of approximately $1 billion of loans in the second quarter. The loans in the portfolio sold at higher LTVs. This resulted in a reduction of the remaining weighted average portfolio LTV at the end of the second quarter by two points. Throughout the pandemic, our relationships with our originators remain strong. We are working with our partners to be a stable source of liquidity moving forward. Approximately half of the portfolio is now financed with non-mark-to-market leverage. We expect to be a programmatic issuer of securitizations, which will further increase the percentage of non-mark-to-market funding in addition to lowering our cost of funds. Turning to Page 13. A significant percentage of borrowers in our Non-QM portfolio have been impacted by the pandemic. Many of our borrowers are owners of small businesses that were affected by shutdowns across the nation. We instituted a deferral program in March with our servicers in an effort to help our borrowers manage through their crisis while maintaining value for our shareholders. Any borrower that was current leading up to the pandemic and raised their hand during the months of March, April and May, saying that they were impacted were granted a deferral until the June 1 payment and were reported as current through that time period. Looking at the table on the right-hand side of the page, you can see the cumulative percentage of loans impacted by COVID increased over 30%. As of June 30, we are happy to report that over two-thirds of the borrowers that received COVID-related deferrals have made one or more payments post-deferral conclusion and continue to be current. Turning to Page 14. Our RPL portfolio of $1.2 billion has been impacted by the pandemic, but continues to perform well. Eighty-three percent of our portfolio remains less than 60 days delinquent. Although the percentage of the portfolio of 60 days delinquent was 17%, over 20% of those borrowers continue to make payments. Prepay speeds in the second quarter slowed down a bit from elevated speeds seen previously; however, they have maintained within our expectations and we could see them tick up a bit in the coming months given the mortgage rate landscape. This portfolio exhibited a similar percentage impacted by COVID as the Non-QM portfolio. We are working with our servicers to ensure positive outcomes post-forbearance. Turning to Page 15. We are fortunate to have an exceptional asset management team managing through our portfolio of nonperforming loans. The team has worked through the pandemic in concert with our servicing partners to maximize outcomes on our portfolio. This slide shows the outcomes for loans that were purchased prior to the second quarter ended of 2019, therefore owned for more than one year. Thirty-four percent of loans that were delinquent at purchase are now either performing or paid in full. Forty-six percent have either liquidated or are REO to be liquidated. We have significantly increased our activity, liquidating REO properties, selling 90% more properties versus the second quarter a year ago. Twenty percent of loans are still in nonperforming status. Our modifications have been effective as three-quarters are either performing or paid in full. We are pleased with these results as they continue to outperform our assumptions at the time of purchase. And now I'd like to turn the call over to Gudmundur to walk you through our business purpose loans.

Thanks, Bryan. Turning to Page 16. The COVID-19 pandemic negatively affected fix and flip borrowers as project completion and home sales slowed down dramatically in April and May, and borrowers in general were negatively impacted by the severe contraction in economic activity caused by the COVID-19 pandemic. As a result, principal paydowns slowed down and delinquencies increased in our portfolio in the months of April and May, for stabilizing and/or recovering slightly in June. MFA's Fix and Flip portfolio declined $116 million to approximately $860 million in UPB at the end of the second quarter. Principal paydowns were about 65% of pre-COVID levels in April and May, but recovered almost fully in June for a total of $135 million of principal paydowns, equivalent to about 45% CPR on an annualized basis. The third quarter looks on track to continue this trend with principal paydowns in July exceeding $50 million. We advanced about $26 million of rehab draws and made no new investments in the quarter. The average yield on the Fix and Flip portfolio in the quarter was 5.73%. As part of our exit from forbearance, we refinanced our existing secured financing and borrowed against previous untouched loans. All of our Fix and Flip loans are currently financed at two-year term non-mark-to-market debt with the cost of funds of around 4%. Delinquencies in our portfolio increased as borrowers struggle with delays in costly transactions, slow down of rehab work, and impaired personal financial conditions due to the COVID-19 pandemic. We implemented the payment deferral program with multiple services, where borrowers were assessed on a case-by-case basis to determine if our short-term payment deferral would be beneficial to the borrower and loan outcome. Borrowers were required to document the negative impact from COVID-19 on the profits of the project. The granted payment deferrals typically lasted three months and affected about 1.5% of outstanding loans in the quarter. Turning to Page 17. As previously noted, we saw delinquencies increase in the quarter with loans 60-plus days delinquent increasing by approximately $70 million or 10% to approximately $182 million or 21% of UPB at the end of the second quarter. Seven and a half percent of the increase was due to new delinquencies, while 2.5% of the increase was caused by a lower portfolio balance due to paydowns. MFA is fortunate to have a highly experienced and talented asset management team that has for years consistently improved outcomes in loss mitigation efforts on our residential whole loans, particularly our nonperforming loan portfolio. The team consists of individuals with extensive experience in designing loss mitigation strategies and handling title issues, bankruptcy filings, and other common issues that can emerge while dealing with seriously delinquent loans. We work closely with our services and are confident that our hard work will lead to acceptable outcomes. Approximately two-thirds of the seriously delinquent loans are at a completed project where bridge loans were limited or no work is expected to be done, meaning these properties should be in decent condition. Additionally, approximately one-third of the seriously delinquent loans are already listed for sale. Reserves of $30 million were recorded as of June 30 for expected credit losses; this is modestly down from $35 million at the end of the first quarter. Loss reserves are recorded in earnings, and these numbers have therefore already been reflected in our first and second quarter earnings. We believe our asset management team provides us with a huge advantage in loss mitigation. Additionally, because we have secured term non-mark-to-market financing on our entire Fix and Flip portfolio, we will be able to patiently work through our delinquent loans to achieve acceptable outcomes. An additional mitigating factor is the lower level of reps and warranties made by originators at the time of loan purchase. We currently have eight purchased claims outstanding of $7 million of seriously delinquent loans, where we agreed with services that these loans will be purchased over time. Finally, on a macro level, we believe that fiscal and monetary policy is supportive of home prices. As the Fed has lowered rates and purchased assets, mortgage rates are at all-time lows and home sales will recover from the depressed levels in April and May. Turning to Page 18. Our single-family rental loan portfolio held up reasonably well in a tough quarter. The size of the portfolio was relatively unchanged at $490 million as prepayments remained low due to strong prepayment protection, and we made no new investments in the quarter. The portfolio yield remained relatively unchanged in the quarter at 5.8%. Sixty-plus delinquencies increased to 5% in the quarter. We primarily saw delinquencies increase in the months of April and May, stabilizing in June, and we have seen some positive delinquency trends post-quarter end. Similar to the Fix and Flip portfolio, we worked closely with our services to implement a payment deferral and forbearance program that borrowers will assess on a case-by-case basis to determine the benefit of a deferral. We granted payment deferrals usually for three months and about 3% of outstanding loans in the quarter. We believe that fiscal and monetary policy has been helpful from a credit perspective for our business purpose loans. Additionally, short-term pushes for borrowers to move from new rental apartments in densely populated cities to single-family homes for more space, as well as long-term trends toward increased single-family rentals, is supportive of our SFR assets. I will now turn it over to Craig for some final comments.

Thank you, Gudmundur. The second quarter of 2020 for MFA was unprecedented in so many ways. Through an unwavering determination and a Herculean effort on the part of all of our dedicated team, we have repositioned and restructured our company so that once again, we can focus on creating value for our shareholders. While we are still somewhat cautious about the macroeconomic environment today and the still unknown post-COVID-19 world, we believe that we are positioned to weather future storms while we evaluate investment opportunities, manage our capital structure and look to grow earnings. Greg, would you please open up the line for questions?

Your first question comes from the line of Steve Delaney from JMP Securities.

And first, just congratulations on all your work over the last five months now to position MFA to be able to move forward. I'm hearing that given your financing package with Apollo and Athene and everything, it sounds like you guys are kind of chomping at the bit to put some of that $600 million of cash to work. If I'm hearing you right, it's probably going to be the NQM loan product with an eye towards securitizing that. First, I guess, am I hearing you correct on that? Can you just give us an update? Have you started buying any loans here in August? Is that effort kind of well underway? Additionally, you've got almost $6 billion of loans. Should we expect that this focus on securitization will also include working to structure securitizations on those existing loans?

Sure. Thanks for the question, Steve. The first thing I would say is as much as we feel good about having a high cash balance, I wouldn't say that it's necessarily burning a hole in our pocket, and we need to go invest it tomorrow. As Bryan said, most of the originators, if they didn't shut down, they almost shut down for several months, and they've started to originate again. I think it'll probably be another month or so before we see any sort of volume of closed loans to purchase just because the underwriting process takes some time. It’s certainly on the agenda, but it hasn't happened yet; however, I think we are certainly close on that. In terms of securitization, spreads are not quite as tight as they were back in early March, but they're pretty close. There’s an upcoming deal at the price this week—AAAs were maybe 125 over swaps. Swaps are still low right now. The securitization execution is really compelling. Irrespective of your question about the existing portfolio, originators have not been that active the last few months. Some of the dealers that are active in securitizations are a little worried about where their volume will come from for the next month or two while everybody ramps back up. We have a great opportunity to securitize the existing portfolio. The securitization execution is substantially more attractive than non-mark-to-market financing—probably on the order of 100 basis points or a little bit more—and could provide twice the amount of leverage even if only selling down through single A. So it's very compelling right now, and the supply-demand dynamics are good. I think we have an array of investment considerations we can make, but one of those is paying down a portion of the note from Apollo and Athene at a fairly high-interest rate; it’s easy to calculate the ROE there. So we will consider deploying cash across various options.

Great. That paydown—interesting you say that—some of the rescue financing we've seen has had a minimum required interest payment over one or two years. It sounds like you have more flexibility where you're not locked into having a certain amount outstanding for a period. Am I correct in that?

You're correct. It's callable right away, and I'd like to take credit for that; however, there was actually someone else that broke the ground on that in getting callable debt, so we were able to take advantage of that as well.

Our next question comes from the line of Henry Coffey from Wedbush.

And let me add my congratulations. An enormous amount of work has been done, and a lot of value preserved. If you look through your existing assets to home values, which are actually holding up fairly well on a national basis, what would the outcome be if you had to go to foreclosure on a lot of these properties? Would you be able to recover par? Would it create a manageable loss? That's obviously not the solution you want to pursue, but what would it look like if you did pursue that avenue?

Sure. I'll provide an overview and let Bryan and Gudmundur discuss some specifics. We did take some allowances for credit losses at the end of the first quarter. While I can’t say we will get par on everything because we've established loss reserves, you're right that home prices have held in pretty well. Mortgage rates are at historic lows, and consider what the LTV was of the loans—the Non-QM portfolio LTVs are typically mid or high 60s, and the fix and flip portfolio is similar. We believe we have a good cushion, but it takes time to work through those, more time on Non-QM than fix and flip because those are business purpose loans that are not owner-occupied. This solidified financing is to work through those loans and achieve good outcomes.

Right. Regarding the Non-QM portfolio, with a weighted average LTV of 63.5%, the most likely outcome of a borrower in distress is a sale of the property on their own. We probably won't have to go through foreclosure. If we had to, it’s likely to go to a third party, potentially resulting in no loss. Looking at the three years we've held loans, we've had one or two go to REO, and that property is not expected to take a loss. So far, so good, but we also have to consider downside scenarios.

It mainly sounds like the issue is time, and you have time.

That's right.

That's exactly right, Henry.

I would just add that home prices have held up better than expected, primarily due to fiscal policies which support home prices while mortgage rates are at historic lows, leading to a recovery in home sales from depressed levels in April and May.

Your next question comes from the line of Doug Harter from Credit Suisse.

You talked about how the forbearance financing was more expensive and a drag on the second quarter. Can you discuss the new financing levels relative to what you were paying in forbearance? Also, help us understand the pacing of securitization to achieve those cost savings that you mentioned.

Sure. Forbearance interest, suffice to say, was very expensive—probably LIBOR plus 500, maybe even a little more. It’s not indicative going forward. We have details in the press release where we laid this out by product type. The secured financing away from the Apollo, Athene large loan and securitizations has an average cost of about 3.6%. It will vary by product type, but generally speaking, it's probably in the vicinity of LIBOR plus 300 to, in some cases, LIBOR plus 400. Regarding securitization, we were one day away from pricing a Non-QM securitization on March 16. This is our single highest priority right now, and the timing is good as there aren’t many deals in the market, and the executions have continued to improve.

How can we think about the sizing? Is the size you were looking at before the right size? Could you do bigger? Just how should we think about that potential for sizing?

That's a good question. We are not a first-time securitizer, but for Non-QM loans, this will be our first securitization. So for the first deal, we probably don't want to bite off too much and want to ensure that it's an orderly deal that gets good execution. The deal we were close to doing back in March was around $400 million. That’s a good place to start, and depending on demand, we could consider growing that. The existing Non-QM portfolio is about $3 billion, so we have a lot of securitizing to do.

Your next question comes from the line of Rick Shane from JPMorgan.

I wanted to talk a little bit about the allowance on the Non-QM portfolio. I realized there was a significant reduction related to the sales, which makes sense. However, when we look at the characteristics, there doesn't seem to be a substantial change in portfolio quality. I am curious about the driving factors for that discrepancy. Additionally, what timeframe are you using for your economic outlook as you compare to March 30 and June 30?

Rick, I would point out that we implemented CECL in 2020. When you compare to December 31, it was a different accounting standard back then. Steve, do you want to address that?

When we look at loans, we back out the reversal of the adjustment that we made at March 31 on the loans that were being sold. The reduction in the Non-QM reserve was about $2.3 million for the three-month period. The statistics show that the delinquency levels and FICO and LTV metrics are not significantly different. The CECL reserve reduction is driven by some of our assumptions in April around unemployment that we've adjusted slightly. We've dialed those back a little as of the end of the second quarter while being aware of the uncertainty regarding potential double-dips due to state closures. We still feel that our unemployment assumptions are appropriate for the second quarter, and that's what drove the reduction in the Non-QM CECL reserve.

To be clear, it may be a bit confusing with the presentation—there was a $70.2 million valuation adjustment on our Non-QM loans at 3/31. This was based on a large pool we sold that I referenced. The $70 million was a write-down to adjust the mark on March 31. Then the sale occurred and got reversed, so it was never part of a credit loss allowance.

Got it. That makes sense; you're saying the fair value mark was higher than the CECL reserve for the remaining portfolio. With a relatively large migration into July, should we expect the CECL reserve to continue to build as more loans cascade from 30 to 60 or potentially beyond?

So Steve, do you want to address that? We have a separate process for delinquent loans than we do for CECL reserves in general.

In August, the 30-day population for the Non-QM portfolio was between 3% and 4% delinquent. That means about 7% will be 60-day delinquent in July. We saw a mix where half stayed in the 30 day, some moved to 60, and others became current. Thus, the 30-day bucket is not sort of a growing number; it's more of a one-time focus on COVID impacts.

Thank you for the detail. I appreciate that.

We have a question from Eric Hagen from KBW.

I had a similar question as Rick. The net earnings from the nonperforming loan portfolio were $20 million last quarter. What's the outlook for returns there? I know you don't typically assign a yield to that portfolio, but how should we think about earnings potential? Is your portfolio of REO pledged as collateral for any of your funding loans, or is it essentially held as equity?

Your assumption is correct—the REO portfolio is not encumbered at the present time. We own all of those with equity. Regarding fair value/nonperforming loans, we expect returns to remain in the range of 5%-7% over time. I don't think that's changed. The income we show is not just from mark changes but also the cash received from loans that are now performing. However, the fair value mark change was only about $2 million for the second quarter.

Great. I feel like just to clarify around any runoff that might be reinvested later. What's the current status in the third quarter? Have you been able to reinvest paydowns? Or is liquidity being retained for the near future?

We are in conversations with originators. I would say we're close to start putting out some money again. But we’re proceeding cautiously; we don't know what the post-COVID world looks like and if we'll see another downturn. We are in a good position with our balance sheet and liquidity, but we may deploy cash somewhat conservatively at least in the short term.

As the market recovers, could you entertain selling a portion of the Non-QM portfolio?

I suppose we could, but it's not our intention right now. We sold some in April that closed in May, but I don't see loan sales making much sense at this point. I believe securitization is a more favorable route, especially given the current rates and spreads.

At this time, there are no further questions.

Well, thanks everyone, for your interest in MFA Financial. We look forward to our next update after the third quarter in early November.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect.