Mfa Financial, Inc. Q4 FY2022 Earnings Call

Thank you for joining us for the MFA Financial Fourth Quarter 2022 Earnings Call. This call is being recorded. I would now like to introduce our host, Harold Schwartz.

Thank you, operator and 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, 2021 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 that 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 fourth quarter 2022 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, Harold. Good morning, everyone and thank you for joining us here today for MFA Financial's fourth quarter 2022 earnings call. Also with me today are Stephen Yarad, our CFO; Gudmundur Kristjansson; and Bryan Wulfsohn, our Co-Chief Investment Officers and other members of senior management. The fourth quarter of 2022 was yet another wild ride to punctuate what was one of the most difficult years ever for fixed income and for the mortgage market, in particular. Rates ended the fourth quarter only slightly higher than they were at September 30 but the path is anything but straight. 2-year treasuries began the fourth quarter at 4.28% and sold off to 4.72% in early November before rallying back to close out the year at 4.43%. After beginning the quarter at 3.83%, 10-year treasuries hit a high for the year of 4.24% in late October before rallying back in the year almost unchanged at 3.87%. This volatility in the rates market impacted the mortgage market with agency mortgages widening out in late October to the widest level since the great financial crisis. RMBS securitization markets, while technically not closed, were quite dysfunctional, with AAA cash flows widening even more than Agency MBS spreads. As breathtakingly bad as 2022 was for fixed income and mortgage participants, it was not a total surprise to us at MFA. On our fourth quarter 2021 earnings call a year ago, I stated that we expected ongoing rate volatility with inflation rising at the time, the Fed on the move and a tense geopolitical environment. For our first quarter 2022 earnings call, I remarked how similar 2022 felt to 1994 when the Fed raised rates 6 times for a total of 250 basis points. Now we certainly did not have a perfect crystal ball but we began preparing for 2022 in late 2021 and we took additional steps early in 2022 to prepare for higher rates. As market expectations changed in 2022, we took further action to protect MFA from market forces. We had $900 million of interest rate swaps on at year-end 2021. And this is when market expectations were for 325 basis point Fed funds increases during 2022. It seems like a long time ago. We increased our swap book to $2.4 billion by the end of the first quarter of 2022 and to $3.2 billion by the end of May. At the same time, we continued to execute securitizations throughout the year despite higher rates and higher spreads on the rated securities that we sold. There were numerous occasions during the year when we priced the securitization and we were somewhat disappointed with our execution, only to be ecstatic a week or two later that we had printed the deal when we did. The securitizations complemented our interest rate swap positions by effectively fixing our future funding costs and, at the same time, reduced our exposure to margin calls on repo and warehouse funding. Our management of MFA's funding cost is historically evident when you look at our cost of funds, particularly in the fourth quarter of 2022. We stated on our third quarter earnings call that 99% of our asset-based financing costs were effectively fixed either through securitizations or interest rate swaps. Our cost of funds in the fourth quarter was 3.7% which is only 10 basis points more than it was in the third quarter. And this despite the fact that the Fed raised rates 125 basis points in the fourth quarter and 200 basis points since their meeting in September. Many others in our space saw funding costs increase by 100 basis points or more in the fourth quarter. In fact, our funding costs were only 32 basis points higher in the fourth quarter than they were in the second quarter though the Fed raised rates by 350 basis points between June '16 and December 31. As a result of when we entered into our interest rate swaps, our weighted average fixed pay rate was 1.69% at December 31. Given the current level of SFR, our interest rate swap book now generates a positive carry of close to 300 basis points and this positive carry will increase further as Fed funds rates increase further. Finally, as we added assets at increasingly higher yield, our net interest spread has increased in both of the last two quarters. Our book value was down very modestly in the fourth quarter and was down a little over 20% for the year; our economic return for the year was down 13% on GAAP and 16% on economic book value. While this is a disappointing result for MFA, our proactive hedging and liability management limited the book value decline as others saw declines in book value for the year of between 30% and 50%, and economic returns for the year down 25% to 40%. Importantly, our book value decline is overwhelmingly due to rising rates rather than to weakening credit fundamentals. In fact, our loan portfolio is marked $732 million below par or $7.19 per share. To be fair, our securitized debt is also marked below par by $368 million or $3.62 per share. However, netting the two and assuming that our loans pay off at par and that we pay off our securitized debt at par, we have a potential upside in our economic book value of $3.57 per share. Page 8 of our earnings deck lays out this case, together with the strong credit fundamentals that support the loan portfolio. Looking ahead to 2023, this year has been anything but boring thus far. Rates rallied through January as bond market participants became increasingly confident that inflation trends were improving and expectations of further Fed tightening diminished. Agency mortgages looked attractive, particularly on a historical basis, at the end of January. The Fed announcement and press conference on February 1 provided further fuel to this rally. However, queue up the January employment report which came out in early February, followed by hot CPI and retail sales numbers, and the bond rally suddenly became a bond rout with treasury yields back near November highs. Once again, we learned that mortgages may seem cheap but that doesn't mean they can't get cheaper. Credit markets have been considerably more constructive thus far this year with securitization spreads for AAA loans at least 100 basis points tighter than they were in November. After pricing just one securitization of $235 million of loans in the fourth quarter, we've already executed three securitizations in 2023 totaling over $650 million. Not only were these spreads tighter for these deals, but they were priced before the recent sell-off in rates. It seems clear that the Fed is neither certain about the magnitude of further rate increases nor clear on how long they will need to hold rates at restricted levels to break inflation. However, it is quite clear that the game is not over. We can debate whether or not we're in the middle innings, but we're definitely not in the ninth inning. Our rate strategy remains in place as it has been since the second quarter of last year. We'll continue to prioritize liquidity. We'll continue to securitize loans and we'll adjust market pricing and yields on our asset purchases to conform to market rates and funding costs. Finally, I would like to touch on housing and residential mortgage credit. Clearly, the selloff in rates and widening in mortgage spreads has had a profound impact on mortgage rates and housing activity, which has slowed dramatically. We are beginning to see some modest home price declines, at least month-over-month, in some regions of the country. Following the dramatic home price appreciation over the last two years, this should not be a surprise to anyone. However, as we again show on Page 8, our loan portfolio contains considerable embedded HPA which, combined with amortization, has lowered the current LTVs in most cases to the mid-50s. Additionally, delinquency trends have continued to improve across our portfolio. I'd like to turn the call over now to Gudmundur to talk about our portfolio activity and Lima One.

Thanks, Craig. First, let's turn to asset acquisitions. The combination of higher rates and our unique ability to source business purpose loans and non-QM assets allowed us to add high-quality credit investments at coupons not seen in a long time, and perhaps never, in the fourth quarter, with the average coupon on purchased loans around 9.5%. To put that into perspective, the average coupon on loans added was over 140 basis points higher compared to Q3 2022 and about 440 basis points higher than Q4 2021. Importantly, the credit quality of our acquisitions remains excellent, with an average LTV of 65% and average FICO above 740. We acquired $481 million of loans in the quarter and continued to find the best opportunities in business purpose loans originated by Lima One, where we were sourcing these assets substantially below the cost of purchase from third parties and can efficiently control the credit process. These accounted for about 80% of our loan acquisitions in the fourth quarter with the remainder being selective acquisitions of non-QM loans. 2022 was the first full year that Lima One operated under MFA's ownership and marked the year when Lima emerged as a leading nationwide BPL originator, achieving strong origination volume, excellent credit performance and prudent underwriting. Lima originated a record $2.3 billion in 2022, a 42% increase over 2021 and demonstrated its importance to MFA's balance sheet, with Lima One originated loans accounting for roughly 2/3 of MFA's loan acquisitions in 2022. The progress made in 2022 was due to clear strategic planning and outstanding human resources. The collaboration between the talented and creative team at MFA and Lima has yielded tremendous benefits, and the teams have worked tirelessly to execute our strategic vision in the BPL space. I believe we're just getting started, and the market volatility over the last 12 months and going forward has and will continue to create opportunities for Lima to grow market share in the BPL space. Lima One possesses many strengths. Key among them is our strong focus on credit quality and risk management, which, combined with disciplined underwriting and in-house servicing and construction management teams, has led to very low delinquency levels on our Lima One BPL portfolio, which has less than 2% of 60-plus day delinquency as of December 31. Furthermore, Lima's origination does not exhibit excessive geographic or borrower concentrations. No state accounts for more than 15% of our Lima One business purpose loans, and no borrower exposure exceeds 2% of our Lima One BPL portfolio. Another important strength is Lima's broad product offerings of both short-term and long-term financing solutions to experienced real estate investors, allowing us to maintain strong origination volumes through various economic and interest rate cycles. One area where the benefits of our collaboration have been very evident is in the securitizations of our business purpose loans. MFA has securitized over $1.4 billion of Lima One originated loans since our acquisition in mid-2021. We have securitized both short and long-term business purpose loans and created a differentiated platform where origination, servicing, asset management, and risk retention all exist under one roof. This control over the credit process and alignment of interests has resonated well with bond investors and helped us close our second transitional loan securitization in February, marking the first marketed transitional loan securitization in over 6 months. These securitizations are non-rated, and this market effectively closed in the second half of 2022 due to widening spreads. Great credit is owed to our team for reopening this market and executing swiftly as rates and spreads declined in early 2023. We securitized about $150 million of transitional loans and now have over $400 million of this type of revolving securitization outstanding. Throughout 2022, we focused on the impact of higher rates, tighter monetary policy, and potentially softer economic conditions on our portfolio. To address those risks, we tightened underwriting standards and increased risk-based pricing adjustments and loan coupons throughout last year. As a result, we observed loan demand softening towards the end of last year, with Lima's Q4 origination volume down about one-third to $406 million. We expect Q1 origination volumes to remain soft but are optimistic about BPL origination volume for the remainder of the year and anticipate origination volumes will trend higher throughout 2023 as market volatility and higher financing costs allow Lima One to grow market share. We remain focused on liquidity and the availability of financing to support our BPL origination, and to that end, we expanded our RPL warehouse financing capacity by $100 million in the fourth quarter and by another $200 million so far in 2023. I will now turn the call over to Bryan Wulfsohn, who will discuss MFA's securitization activity and portfolio credit performance in more detail.

Thanks, Gudmundur. 2022 proved to be a challenging year in the market for securitization issuance. MFA successfully navigated those conditions, issuing $2.3 billion of non-recourse securitized debt through 9 securitizations across our different loan types. We were very active in issuing over the first three quarters of the year, and that aggressiveness allowed us to be patient in the first quarter, issuing only one additional securitization while the spread to treasuries on AAA bonds moved back to a wide for the year of around 275 basis points. For reference, AAA spreads on non-QM and SFR started 2022 in the low 100s and moved higher throughout the year with only a brief respite in the summer before widening again. The patience exhibited in the fourth quarter paid off early in 2023 as spreads on AAAs tightened by over 100 basis points, and we have already issued another 3 securitizations totaling over $0.5 billion in bonds sold. We will continue to be a regular issuer in the market as we believe non-mark-to-market securitization financing provides significant benefits to our portfolio. Moving to our credit performance, 2022 marked a positive year of credit performance for the portfolio. Delinquencies on our purchased performing portfolio improved to 3% from 4% a year prior. The percentage of loans 60 or more days delinquent in December remained stable for the non-QM and SFR portfolios between 2% and 3%. The transitional loan portfolio improved further to 5%. And the RPL portfolio exhibited 17% 60-plus delinquencies, with over 40% of those delinquent borrowers making payments. In the portfolio of loans purchased as NPLs, we had 41% of the remaining loans 60 or more days delinquent, but 31% of those borrowers are making payments. We once again had a successful quarter, liquidating properties from the REO portfolio. Over the quarter, we sold 83 properties for $29 million, resulting in $7.4 million in gains. Over the full year, we sold 416 properties for $134 million, resulting in $29 million in gains. We remain focused on our remaining non-performing loans as momentum has shifted in home prices. Our asset management team is working to ensure our timeline to resolution remains as short as possible as protracted timelines can be costly. As a mitigant to extended timelines, our portfolio maintained a low LTV aided by the significant HPA experienced over the past 2 years, which helps limit potential losses. Overall, we believe the credit in our portfolio is well-positioned for the current uncertain economic environment. And with that, we'll turn the call over to the operator for questions.

Our first question will come from JMP Securities and the line of Steve Delaney.

Congratulations on a strong close to 2022. Again, if you look at the $0.48 distributable EPS in the quarter, obviously, a big improvement from the third quarter of $0.28. If we look at it in a more comprehensive way and put it in terms of distributable return on your economic book value, that puts us at an annualized rate of around 12% to 12.5%. As you know your business better than anybody, do you see that as a reasonably sustainable level? Does it reflect the kind of ROEs that you're seeing in your current securitizations, the deals that Gudmundur talked about in the first quarter of '23? Are they being executed with returns consistent with what you put up in terms of an economic distributable return on economic book value in the fourth quarter?

Sure. The $0.48 was influenced by a couple of factors that I will let Stephen address. Then maybe Gudmundur or Bryan can discuss the static ROEs on the most recent securitizations. Would that be helpful?

Thanks, Steve. This is Stephen Yarad. The $0.48 that we reported in the fourth quarter did benefit from some large items that occurred which may not necessarily recur in future periods. On the interest income line, there was an MSR note redemption that added $7.8 million to the net interest income for the fourth quarter. We also had considerable payoffs of delinquent loans that added about another $2.5 million to net interest income in the fourth quarter. We also had a particularly large gain on the liquidation of an REO property that added about $2.9 million. Although we consistently have REO gains, this was a notably large one, and you wouldn't typically expect a single property to yield that level of gain in any individual quarter. Finally, our compensation benefit number in our G&A was about $4 million lower this quarter than our regular run rate due to the finalization of year-end bonus accruals at both MFA and Lima One, along with a slight drop in commission expenses at Lima due to lower origination volume. So those details should help you adjust to a more normalized run rate.

Those are very helpful for us to try to adjust to something of a more normal run rate type of number. So thank you for that detail.

To briefly discuss our returns: our approach is to acquire loans and add new assets at levels where we can execute securitizations with returns typically around the low to mid-teens range. Currently, the loans originating at Lima One are coming in around a 10% coupon or slightly above that. The equity piece earns about 10%, with securitizations using leverage bringing us into the mid-teens ROE. We are also seeing transitional loans realizing mid- to high-teens ROE on execution.

Next from Credit Suisse, Douglas Harter.

Gudmundur, I hope you can give me more clarity on one of the comments you made about the cost to originate at Lima One versus the cost to acquire from third parties. Could you provide some details around that comment?

Sure. Simplistically, if you are acquiring loans from third parties, you typically pay premiums for those loans, whether they are longer-term restoration loans or RPL loans. Therefore, your returns or yields are naturally lower than the coupon added to your balance sheet. This can vary depending on market conditions, but the magnitude can be as high as 200 basis points lower than where you might create it yourself. Running Lima allows us to collect origination fees and other fees related to the origination process. Our business strategy is to have those fees essentially offset the costs of running Lima, thereby significantly improving our returns by generating these loans on our balance sheet.

To be clear, where are you today on current volumes regarding the goal of having the origination fees offset the costs? Additionally, what are your expectations for volumes this year?

In 2022, early to mid-year, we were on track to have the origination fees offset our costs as volume increased, showing efficiency. However, in Q4 and Q1, volumes decreased. Thus, we were likely running slightly in excess in terms of costs versus origination fee income. As we transition into 2023, we expect this to equalize as our pipeline is increasing, and we anticipate a pickup in volumes for the year. Our optimism stems not from a dramatic expansion in borrower demand but from the understanding that Lima continues to gain market share due to increased financing costs putting pressure on weaker originators. As such, we are attracting higher quality borrowers, leading to superior delinquency performance compared to other players in the market. We believe these factors will be beneficial for us in 2023.

Next from KBW, Bose George.

I just wanted to follow up on Steve's question regarding returns. How do the returns look on your in-place portfolio? Can you provide any specifics on the current portfolio?

You can look at the asset allocation table in the press release, which breaks out the yield on average interest-earning assets and average cost of funds. We referenced the $3.7 billion that increased by only 10 basis points in the fourth quarter. Additionally, that table provides the breakdown by product type, along with our leverage number.

That doesn't capture the accretion, right? Because you also have discount securities that will be rolling back into your ROE, correct? The $3-plus that you referred to in terms of the discount in your portfolio?

Yes, correct. Those do flow through to GAAP earnings but, for distributable earnings, we back out any unrealized gains and losses. So that $3 number is mainly a book value potential accretion. If we receive par on the loans and pay off the securitized debt at par, that’s the upside. Even if the mortgage rates are below market, they still pay off at par, which may take longer than originally expected, but they will pay off. Additionally, any amortization will come through at $0.10 on the dollar as well.

That makes sense. I was just trying to gauge the economic return the portfolio generates. But yes, that’s fair. Also, if I may ask, what’s the current book value? Where does it stand quarter-to-date?

I can tell you what it was at the end of January; it was up about 7% to 8% for the month of January. However, I expect that, given what rates have done in February, we've likely given a lot of that back. I don’t have up-to-date numbers on that.

Next from BTIG, Eric Hagen.

I have a few questions. Looking at the non-QM portfolio and the fundamentals, can you describe the bullish case there, especially in comparison to a levered agency strategy? What are the prepayment speeds on the non-QM portfolio? Are there any expectations for them to get pulled forward? Furthermore, last year saw many older non-QM loans getting securitized, but how do those older loans compare to returns on freshly originated non-QM? Lastly, regarding the nonperforming loan portfolio, what are the solutions to expedite the timeline to resolution? Can you share how you are financing the NPL portfolio currently?

Certainly. In terms of the comparison between non-QM and agency mortgages, we've observed that agency speeds have dropped more significantly than non-QM, because non-QM borrowers may still have an opportunity to get a conforming loan if they manage to compile documentation to qualify for such a mortgage. Over the last quarter, we saw speeds drop to around 7% CPR for non-QM, whereas the agency books might have been closer to 4%. So, we still expect that natural turnover rate to be a bit higher for non-QM. Regarding the returns, on non-QM opportunities, spreads are close to $350 to $400, varying depending on speed. Because of rate volatility, prices for non-QM loans are somewhat near par, due to the high uncertainty around rates. Therefore, newly originated non-QM loans can still yield returns, since spreads on these loans remain in that favorable range. For securitization, spreads are around the 150s for AAAs and the lower 200s for AAs and As. This indicates plenty of excess spread on the newly originated loans, enabling that mid- to low-teens ROE that Gudmundur previously mentioned. Concerning our nonperforming loan book, we are actively taking steps to ensure that timelines remain short. Given our experience with these loans over the past seven years, we've built a solid network with servicers that assist with foreclosure and bankruptcy processes. Our asset management team is also well-equipped to handle these situations. It's important to note that we haven't added new loans to this portfolio in a while. Over time, we have seen a shift in geographic concentration, particularly towards judicial states where timelines tend to be longer. However, we've witnessed a lot of movement toward properties in REO, leading to full payoffs due to equity positions and favorable LTV situations.

There are no other questions in the queue at this time.

Thank you all for your interest in MFA Financial. We look forward to our next update when we announce our first quarter results in May.

Ladies and gentlemen, this conference will be available for replay after 12 noon Eastern Time today, running through May 23 at midnight. That does conclude our conference for today. Thank you for your participation and for using the AT&T Event Conferencing Service. You may now disconnect.