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Cherry Hill Mortgage Investment Corp (NYSE:CHMI)

Q2 2014 Results Conference Call

August 12, 2014 – 5:00 PM E.T.

Executives

Michael Hutchby – Controller

Jay Lown – President & CIO

Julian Evans – Senior Portfolio Manager

Marty Levine – Cherry Hill Mortgage Investment Corp – CFO

Analyst

Steve DeLaney – JMP Securities

Operator

Greetings, and welcome to the Cherry Hill Mortgage Corporation's second quarter 2014 conference call.

[Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to Mr. Michael Hutchby, Controller for Cherry Hill Mortgage. Thank you, Mr. Hutchby You may now begin.

Michael Hutchby

Good afternoon. We’d like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's second quarter 2014 conference call. In addition to this call, we have filed a press release that was distributed today 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, IRRs, future expected cash flows as well as prepayment and recapture rates, delinquencies, and non-GAAP financial measures such as competitive income.

Forward-looking statements represent management's current estimates, and Cherry Hill assumes no obligation to update 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 Chief Investment Officer. Also present on the call today are Marty Levine, the Chief Financial Officer; Julian Evans, our Senior Portfolio Manager; and Stan Middleman, our Chairman.

And now, I will turn the call over to Jay.

Jay Lown

Thanks, Mike, and thank you, everyone, for joining us today on our second quarter 2014 earnings conference call.

As part of our call, we've posted on our website a presentation that we'll touch upon throughout this call, and we'll reference specific slides when appropriate. After our prepared remarks, we will open up the call for your questions.

Cherry Hill posted another strong quarter, and remains focused on generating consistent, attractive returns for our shareholders. As can be seen on slide 5, the interest rate environment today is quite different than what we saw in the fourth quarter of last year. The healthy rally in interest rates during the month of January carried into a rather muted first quarter, where we remain range bound, and this continued through the second quarter.

The second quarter can be generally characterized as a choppy, reactionary one to economic and political views with a downward trend in rates. More recently, geopolitical instability and global macroeconomic concerns have once again pushed investors into a flight to safety mode, driving US rates even lower.

The drop in interest rates, however, has not resulted in significantly higher mortgage origination volumes thus far in 2014. Refinance activity remains muted, and purchase activity hasn't taken center stage. With the FED on pace to exit QE3 this fall, we expect the non-bank mortgage origination community will compete for a smaller pool of assets, adding additional pressure on margins and forcing many to monetize their MSR assets.

While we expect a substantial amount of mortgage servicing rates to be available for purchase going forward, there is strong demand for these assets, as investors look for ways to deploy capital and assets with negative duration. We remain focused on the SSMSR class to execute our investment strategy, and believe it will remain a compelling investment opportunity over the long term, given our view of interest rates rising as the economic recovery gains steam.

Let's move on to our second quarter results. Turning to slide 6, the second quarter produced earnings consistent with the previous quarter, with another slight increased book value. Our book value per common share rose to $21.62, and we declared and subsequently distributed a $0.51 dividend to our shareholders. Net interest spread for the RMBS portfolio for the quarter was 1.59%, and prepayments speeds for the RMBS portfolio averaged 4.96%, in line with management expectations.

With our excess MSR's unlevered, our aggregate debt to equity ratio at quarter end was 1.8 times, up slightly from the first quarter. Lastly, Freedom's recapture efforts for our excess MSR portfolio continue to deliver outstanding results, especially with respect to Pool 2, which again experienced strong recapture rates over the quarter.

Cherry Hill has a number of initiatives underway as we look to grow our business over the coming quarters and years. As we have previously stated, having the flexibility to purchase the whole MSR should give us a wider potential market from which to acquire excess MSR's. We believe owning the full MSR may allow us to obtain leverage on the asset, thereby maximizing returns on the investment. To this end, we are pursuing the appropriate licenses and approvals to be able to own MSR's within our taxable reap subsidiary. It is our goal to have the R licenses in place within 6 months.

In addition to RMBS and excess MSR's, we are exploring opportunities in the non-agency mortgage space. We are committed to executing our whole end strategy and find prime jumbo loans, non-QM loans, prime second lien loans, compelling business opportunities.

It's our goal to partner with Freedom in these areas, and exploit our strategic partnership as we build out these initiatives. Attractive term funding is integral to the success of these programs, and within this context we are forming a captive insurance subsidiary to pursue membership in a federal home loan bank.

Currently, the FHFA has imposed a moratorium on accepting new captive insurance companies as FHLB members, so we are waiting news on a ruling from the regulators.

Let's move on to our investment portfolio. Slide 7 highlights our aggregate portfolio composition. At quarter end, our excess MSR Investment represented approximately 65% of our equity capital, and approximately 23% of our assets.

Our RMBS portfolio comprised approximately 29% of equity, and approximately 77% of assets. The RMBS portfolio is concentrated in lower duration assets. We maintained a neutral duration gap over the quarter, and at quarter end our direction gap stood at negative point 0.15 years. Julian will discuss the performance of this portfolio in more detail shortly.

Our excess MSR portfolio for the second quarter, which is referenced on slides 8 and 9, performed in line with management expectations, generating significant returns during the quarter. Despite the interest-rate rally, our investments experienced muted market value drift, driven primarily by our ability to dampen higher prepayment expectations through our recapture agreement. The current carrying value of the MSR portfolio in aggregate dropped by $5.5 million over the quarter to $102 million, of which $3.9 million was due to amortization.

Our recapture agreement resulted in over $565 million in loans being recaptured during the quarter. The vast majority in Pool 2, which posted a 55% recapture rate.

Life to date, Freedom has recaptured over $1.1 billion in loans for our portfolio. We are pleased with Freedom's efforts to protect and defend all of our portfolios, and we look forward to working together to improve these results over the coming months as the portfolio seasons. Weighted-average CPR's net of recapture remain within current management expectations.

We regularly seek opportunities to evaluate excess MSR purchases with Freedom. However, as we have said before, we are prudent and deliberate in the deployment of additional capital, as we evaluate all transactions within the context of our investment criteria and return thresholds. During the second quarter, we did execute a full purchase of excess MSR's from Freedom. While nominal in size, we view Freedom as a strong strategic partner, and expect that we'll have more opportunities over the upcoming months, as we complete our licensing project and are able to purchase full MSR's.

Now I'll turn the presentation over to Julian, who will provide some detailed information on the RMBS portfolio and its performance this quarter. Julian?

Julian Evans

Thank you, Jay.

As of June 30th, RMBS portfolio, including TBA's, stood at $343 million, up from $309 million at the end of the first quarter, as shown on slide 10. As Jay mentioned, the portfolio is concentrated in shorter duration assets and was run on modest leverage of 6.14 times. At quarter end, approximately 54% of assets were comprised of 15-year and 20-year fixed rate hold pools, and the remainder in 30-year fixed-rate hold pools, TBA, and hybrid arms.

Loan balance stories remain a majority of the overall collateral composition at quarter end, as shown on slide 11. The portfolio's composition continue to exhibit favorable prepayment speeds, due to its composition posting a weighted average CPR of 4.96% for the quarter. As we mentioned on our first quarter call, the unusual, low prepayment speed will be hard to duplicate going forward.

During the first quarter, the portfolio's slower speed was a combination of collateral composition and seasonal variance, which had some impact on homeowners' ability to refinance. During the second quarter, the portfolio returns to a more normal CPR. The aggregate portfolio is managed conservatively. Given our long-term interest-rate views, and current fundamental mortgage valuations, the portfolio operated with a modest leverage and a fairly neutral duration gap.

As shown on slide 12, we ended the quarter with an aggregate portfolio duration gap of a negative 0.15 years. The portfolio's duration gap remained stable under various interest-rate stress scenarios. Our duration gap would move from a negative 0.15 years to a positive 0.14 years following a 200 basis point instantaneous shock according to our model. The portfolio's gap is driven by the composition of the RMBS portfolio, associated hedges, and the fact that nearly two-thirds of the portfolio's equity was comprised of excess MSR's during the second quarter.

I would now like to turn the call over to our CFO, Marty Levine, who will review our second quarter financial results in more detail. Marty?

Marty Levine

Thank you, Julian.

As Jay stated in his opening remarks, we had another strong quarter. Our comprehensive income, which includes the mark-to-market of our held-for-sale RMBS was $4.9 million, and comprehensive income per share was $0.66. Our GAAP loss for the quarter was $0.7 million, or a loss of $0.09.

Net interest income was approximately $5.1 million in the second quarter. Our holistic hedging strategy produced a combined net increase in assets of excess MSR, RMBS, swaps, and swaptions of $1.1 million. As detailed in slide 25, we use interest-rate swaps and interest rate swaptions 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 had swaps with a notional value of $184 million. At the end of the second quarter, we held swaptions, which allow us to enter swaps with $150 million notional value.

For GAAP purposes, we have now elected to apply hedge accounting for our interest-rate derivatives, and as a result, we record the change in estimated value as a component of the net gain or loss on interest rate derivatives. The majority, or 65% of our capital, is deployed in excess MSR's. Our Investment in excess MSR's are currently unlevered, and our implied debt to equity ratio on the RMBS portfolio, which excludes our TBA position, was leveraged 6.14 times at quarter end.

Our operating expenses increased due to additional infrastructure costs, and costs associated with licensing the mortgage and insurance subsidiaries. For the quarter ended June 30, our total operating expense ratio as a percentage of average equity was 3.2%.

On June 11, we declared our second quarter 2014 dividend of $0.51 per share, which was paid on July 29. It is our goal to distribute regular quarterly dividends of all or substantially all of our taxable income to holders of our common stock and to the extent authorized by our Board of Directors.

For the second quarter of 2014, we had reaped taxable income eligible for dividend purposes of approximately $3.8 million, which represents $0.51 per share for the quarter.

Now, I'd like to turn the call back to Jay for closing remarks.

Jay Lown

Thanks, Marty.

The second quarter produced results that were once again in line with Management expectations. We have a number of initiatives under way that we think will allow us to both increase our ability to invest in core strategies, and pave the way for investments into assets we expect to be instrumental in the continued evolution of the residential real estate markets.

Our primary goal remains being dedicated to delivering consistent, attractive returns to our shareholders, while taking the appropriate risk as we navigate through choppy seas.

We will now open up the call to take your questions. Operator?

Questions-and-Answer Session

Operator

[Operator Instructions] Thank you. Our first question comes from Steve Delaney of JMP Securities. Please go ahead.

Steve DeLaney – JMP Securities

Thank you good evening everyone and thank you for taking my questions. Jay, we saw on July 21st a press release put out by Freedom that among other things said that beginning the middle of July, Freedom would begin to service its own – service loans in-house rather than put in with the sub servicer. Then when I read that on the surface I didn't have much of a reaction with respect to Cherry Hill's as far as any direct impact or connection. But I was wondering if I am missing anything and could there be any strategic benefits from this new capability at Freedom for Cherry Hill in the future. Thanks.

Jay Lown

Hey, Steve. Thanks.

Steve DeLaney – JMP Securities

Hey, Jay. For that information it is correct. In July, Freedom started sourcing its own loans in-house with no originations. But the loans that we are currently – MSR's that we fully invested in are still with loan care in Auckland and the pension is not for those to be transferred anywhere else. But to the extent that we do additional business with Freedom going forward, we absolutely believe that that will be a strategic advantage to last, as we look to Freedom to be a sub servicer or servicer towards Cherry Hill's going forward.

Steve DeLaney – JMP Securities

Your thoughts that that direct connection, would that help on recapture primarily given that no one else would be – excuse me. Go ahead.

Jay Lown

Yes. Sure. So that the recapture is driven primarily through the cost center on the origination front. As I said on a number of occasions that analytics in place at Freedom are well crafts and they do a phenomenal job identifying loans in their portfolio that require attention related to protecting and defending that portfolio. So that squarely fits in the origination on – of the Company. But clearly having the ability to identify those loans through the internally serviced portion will be an advantage to the company.

Steve DeLaney – JMP Securities

Okay, great. Thanks. And I was pleased to hear you say that you’re watching this non agency market closely. And there seems to be some building liquidity with some of the larger banks sponsoring deals in the prime space. I was just curious if you could comment on – give us some idea on possible timing. Would it be maybe early 2015 before we would really see you active? And I guess more importantly than timing, would it be your plan that in terms of those transactions to retain both and book on the CHMI’s book both the SMR's and interest-only strips that might fall out of the securitization?

Jay Lown

Sure. That’s a lot of questions going.

Steve DeLaney – JMP Securities

Sorry.

Jay Lown.

We’ll go with that.

Steve DeLaney – JMP Securities

Sorry about that.

Jay Lown

Definitely our desire to take advantage of the non agency marketing, as I said I think we find the general market, the non QM space and even secondly, the interesting opportunities today. We are in the process of building thoughtfully. As you can imagine, it is not a vibrant market still today and we think we have some time. We are very excited about our aspects to those markets and in respect to the servicing related to that market, I think we’re still somewhat – that will be fluid, which is – as to how we look at that. A lot of that will depend on the final execution with the loans with respect to either securitization or just holding those in whole loan form. As you can imagine, the jumbo market is definitely more securitization from it today than the others are. So, clearly that probably will, first and foremost, in terms of where we end up executing first.

Steve DeLaney – JMP Securities

Okay. Great. Well, thank you for the comments. We will watch closely over the next couple of quarters and see how that plays out.

And just for what it’s worth, Marty, I know that at this time you guys choose not to try to calculate some concept of operating or core EPS, but there are standard methodology that we apply to Mortgage REITs. We do get $0.51, which I just would point out is – thus fully covered dividends for the second quarter. Thank you.

Jay Lown

Thanks, Steve. Thanks to the color.

Steve DeLaney – JMP Securities

Yes.

Operator

[Operator Instructions] We have no further questions at this time. I will turn the floor back over to management for any closing remarks.

Jay Lown

Thank you very much. Taken for joining us today on our call today. We look forward to updating you on our progress on subsequent calls. Have a great evening.

Operator

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time and thank you for your participation.

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