MFA Financial, Inc. (NYSE:MFA) Q2 2019 Earnings Conference Call August 7, 2019 10:00 AM ET
Harold Schwartz - Senior Vice President of General Counsel and Secretary
Craig Knutson - President, Chief Executive Officer and Director
Stephen Yarad - Chief Financial Officer
Gudmundur Kristjansson - Senior Vice President and Co-Chief Investment Officer
Bryan Wulfsohn - Senior Vice President and Co-Chief Investment Officer
Conference Call Participants
Joshua Bolton - Credit Suisse
Eric Hagen - Keefe, Bruyette, & Woods, Inc.
Ladies and gentlemen, thank you for standing by, and welcome to the MFA Financial, Incorporated Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded.
I'd now like to turn the conference over to our 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 of 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, 2018, 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 second quarter 2019 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 2019 financial results webcast. With me today are Steve Yarad, our CFO; Gudmundur Kristjansson and Bryan Wulfsohn, our Co-Chief Investment Officers and other members of senior management.
2019 continues to be a stunning interest rate reversal after a slowly rising, but in retrospect, very benign interest rate environment for much of 2018. 10-year treasuries have rallied 150 basis points since early November, 2018 and two-year treasuries have rallied 140 basis points in the same period.
The yield curve has continued to flattened and even invert in the short-end, and one and three-month LIBOR, while lower recently in conjunction with the Fed ease last week, were still higher than all the 30-year treasuries that is until this morning where now even the long bond yields less than one and three-month LIBOR.
For levered investors in mortgage assets, this environment has been extremely challenging. While we cannot claim to have anticipated the stunning developments in rates, MFA’s investment strategy is very much intentionally not dependent on accurately predicting interest rate moves. MFA’s investment acquisition strategy, particularly our focus on purchased performing loans in which we include Non-QM, fix and flip and single-family rental loans is proving to be a durable model.
The groundwork that we've laid beginning in early 2017 is continuing to gain traction as our origination partners grow their businesses, at least in part through MFA’s consistent capital commitment. MFA’s reputation as a reliable buyer of residential whole loans and dependable capital partners has enabled us to source significant volume of whole loans, including in some cases transactions with limited competition. Despite the difficult mortgage environment, we continue to make investments that provide solid returns on equity.
On the capital side, we issued $230 million of 6.25% five-year convertible bond at the end of May. This is MFA’s first convertible bond issuance and we can now count this as another capital structure tool at our disposal.
Please turn to Page 3. MFA’s GAAP earnings per share was $0.20 in the second quarter, and we paid a $0.20 dividend to common stockholders on July 31. MFA’s has paid a $0.20 dividend now for 23 consecutive quarters. Core earnings was also $0.20 per share in the second quarter.
We acquired over $1.4 billion of assets in the second quarter of 2019, growing our portfolio by approximately $391 million. Our book value was unchanged at $7.11 per share, and our economic return for the quarter was 2.8% or 11% annualized. Finally, our estimated undistributed taxable income was $0.05 per share as of June 30.
Please turn to Page 4. Second quarter investment activity was very strong as we purchased approximately $1.4 billion of assets, including $1 billion of whole loans and increased our portfolio by almost $400 million during the quarter. The majority of our whole loans purchases were purchased performing loans, Non-QM, fix and flip and single family rental, as our acquisition of these assets, again increased over the first quarter to $913 million in Q2.
The process of acquiring these assets is very different from that associated with our other asset classes, as we generally purchased these loans directly from originators rather than from The Street or through bulk offerings.
Through our willingness and ability to explore various arrangements including flow agreements, strategic alliances, and minority equity investments, we've been able to partner with originators to source attractive new investments while enabling them to grow with support from MFA as a reliable provider of capital. We were also able to purchase an additional $350 million of MSR-related assets in the second quarter.
Please turn to Page 5. As we have shown previously, our expanding investments in newly originated loans or purchased performing loans is beginning to have a meaningful impact on our interest income. These loans are included in our loans held at carrying value on our balance sheet. Recall that we also include loans purchased as re-performing loans or purchase credit impaired loans in our loans held at carrying value.
In the second quarter, all loans at carrying value produced $57.9 million of interest income that's versus $101 million for all of 2018 and $49.6 million in Q1 of 2019. More notably, $46.9 million of this $57.9 million was from purchased performing loans, up from $38.2 million in the first quarter.
As we continued to grow our balance sheet, we will add marginally more leveraged, particularly on our residential whole loans held at carrying value. We would expect this leverage ratio will continue to increase modestly as our portfolio assets can easily support leverage of 3x to 4x, whether through repo borrowing or securitizations.
For our credit-sensitive loans, we've committed significant resources to our asset management efforts. We recognized that by immersing ourselves in the complicated and sometimes messy details of managing credit-sensitive loans that we can achieve better outcomes and improved returns.
As good as our third-party services are there's a tangible benefit to direct oversight and involvement in decision-making. And finally, our legacy Non-Agency portfolio continues to perform well and contribute materially to our financial results, generating a yield in the second quarter of 11.3%.
Please turn to Page 6. To summarize our strategy and initiatives for 2019, we expect to continue to increase our investments in purchased performing loans, specifically Non-QM, fix and flip and single-family rental. When and if we are able to grow our other existing asset classes at attractive levels, we will obviously continue to do so. An example of this is our investment of $350 million in the second quarter in MSR-related assets. And as always, we are constantly evaluating new investment opportunities.
Given our track record, we are usually among the first to see new opportunities as we have demonstrated the ability and willingness to help structure these deals and invest in size. We'll likely continue to execute strategic sales of Legacy Non-Agency MBS. This is part of managing a mature portfolio and it includes sales of bonds at relatively high prices with little additional price upside, sales of callable bonds at a premium and sales of low loan count or odd-lot position sizes at attractive round lot levels.
We've managed our CRT portfolio by selling many of the seasoned deals that are trading at very tight spreads and high dollar prices late last year and earlier this year before the rally in rates caused prices of these CRT securities to weaken due to prepayment concerns. And finally, we'll look to optimize our capital structure through the use of additional leverage including securitizations. That said our leverage will likely still be the lowest in the peer group.
Please turn to Page 7. Market conditions have been very difficult for many in our space, particularly as rates have rallied since the end of the first quarter, because MFAs investment strategy is much more mortgage credit focused. We've been able to continue to make sizable investments in assets that produce attractive returns.
We just don't have the exposure to prepayments that most of our peers do and our business and earnings power is much less tied to the shape of the yield curve or stable book value and consistent earnings are a result of an investment strategy that does not depend on accurately predicting interest rate changes and executing reactionary investments in hedging activities.
Through our considerable efforts to partner in creative ways with the handful of originators, we are confident that we'll be able to source additional volume of purchases performing whole loans for the foreseeable future. As we continue to grow these portfolios, we are increasing the earnings power of our business. MFA's investment initiatives are firing on all cylinders. We remain optimistic that we will continue to drive earnings through balance sheet growth.
And now I'd like to turn the call over to Steve Yarad, who will provide further details on the financial results for the most recent quarter.
Thanks, Craig. For the second quarter of 2019, MFA's net income to common shareholders is $89.3 million or $0.20 per share, which represents a $0.01 increase over the first quarter. In addition, core earnings which excludes the impact of the fair value changes in CRT Securities and Agency MBS and related hedges that are included in GAAP earnings hedge period is also $0.20 of the common share, the sequential quarter improvement $0.03.
Please turn to Page 8. Here, we present additional information on the key drivers of net income this quarter, which were as follows. Other income was higher this quarter due to an additional $26 million in net gains on residential whole loans measured at fair value. Loan valuations were higher as yields used to discount estimated cash flows from re-performing loans were just been tighter, in line with the prevailing market pricing.
This increase was partially offset by the following. One, lower realized gains on sale to residential mortgage securities, while we continue to opportunistically manage these portfolios, the overall level of sales, particularly for Non-Agency MBS and CRT securities is lower this quarter.
Two, a higher net loss in net position in 30-year Agency MBS and related hedges. Lower rates again resulted in unrealized gains in our portfolio of 30-year Agency MBS. With these were offset by realized loss on hedging swaps that were terminated in response to the change in duration profile of this portfolio.
And three, relatively flat marks in our portfolio the CRT securities held at fair value. Prior quarter marks were higher due to the reversal in the first quarter of the significant credit spread widening that occurred during the fourth quarter of 2018.
Net interest income this quarter was essentially flat to the prior quarter. Portfolio growth drove higher net interest income from purchased performing loans and MSR-related assets. However, these increases were offset or lowered net interest income on residential mortgage securities due to the combined impact of low yields, portfolio sales and runoff. In addition, our net interest expenses quarter also reflects the impact of the convertible bond issued in June.
Finally, operating and other expenses declined slightly from the prior quarter due primarily to lower expenses associated with servicing our loan in REO portfolios. We also recorded a lower provision for loan losses this period and have purchased performing loans.
And now I would like to turn the call over to Gudmundur Kristjansson, who will provide more details of our investment activity and portfolio performance for the second quarter.
Thank you, Steve. Turning to Page 9. The second quarter was another successful quarter for our investments team as we acquired approximately $1.4 billion of assets and grew our portfolio by $391 million in the quarter. This is the seventh consecutive quarter portfolio growth.
As in recent quarters, most of the acquisitions were focused on the whole loans portfolio and in particular on Non-QM and business purpose loans. In addition, we acquired $354 million of MSR-related assets as we saw a healthy supply of attractive transactions in the quarter. We opportunistically sold $195 million of legacy Non-Agency MBS, CRT securities, RPL/NPL MBS and Agency MBS in the quarter.
Turning to Page 10. Our strategic initiative which we began in 2017 to add Non-QM, fix and flip and SFR loans to our investment strategy continues to bear fruit. And as you can see from this slide, it has been the primary driver of portfolio growth over the last few quarters.
Since the third quarter of 2017, our whole loans portfolio has grown from about 19% of our investments portfolio to approximately 49% or so at the end of the second quarter. The primary reason for this growth has been the Non-QM, fix and flip and SFR loans, which have grown from zero in the third quarter of 2017 to over $3.4 billion at the end of Q2 2019.
In addition, Non-QM, fix and flip and SFR loans now account for approximately 55% of the whole loans portfolio and 27% of the total investment portfolio. We are extremely happy with the progress we've made on executing on the strategy we laid out in 2017 and are excited to continue to grow these holdings in the future.
Turing to Page 11. From the fourth quarter of 2015 to the fourth quarter of 2018, the Federal Reserve raised rates 9x, raising the federal funds rate by approximately 225 basis points. During this period of rising rates, MFA's net interest rate spread has remained attractive and relatively stable.
This is primarily due to our investment strategy, which is focused on acquiring credit-sensitive assets, a benefit from positive credit fundamentals as well as emphasizing assets with short duration, which either through a floating rate coupon or rapid repayment of principal have supported our portfolio performance in a rising rate environment.
As the outlook for the path of Fed Fund that shifted this year, we have actively removed some interest in hedges and not to place maturing swaps. As a result, at the end of the second quarter, 32% of our repo financings are hedges for interest rate swaps, down from 41% at the end of 2018.
As the market priced in, a Fed Fund cuts this year, one month LIBOR has declined by 29 basis points year-to-date within maturity or 19 basis points of the decline happening in the third quarter when the Fed cut rates for the first time in over a decade. Most of our assets financing are based on one or three months LIBOR rates and should therefore benefit from declining short-term rates. To the Fed continue to cut rate, you would expect a financing cost of benefit going forward.
Turning to Page 12. Here, we show the yields, cost of funds and spreads for our holdings as well as the equity allocated to each asset class. Our largest equity allocation currently at approximately 55% of our equity, out from approximately 45% last quarter continues to be towards whole loans at carrying value, which yielded 5.8% in the quarter. The equity allocation in general to as whole loans continues to increase with approximately two-thirds of our equity allocated towards whole loans at carrying value and whole loans at fair value at the end of the second quarter.
Turning to Page 13. Here, we take a look at MFA's interest rate sensitivity. Our asset duration changed little in the quarter and remained relatively low at 157 basis points at the end of the quarter. Our swap notional balance declined by $260 million in the quarter as $100 million of swaps matured and we unwound $160 million of longer-dated swaps as rates rallied and the outlook for interest rate continue to shift towards expectations for lower rates.
Year-to-date, our swap prices have declined from $490 million, which – as mentioned previously, should benefit are financing costs going forward as most of our repo financings of title one or three-month LIBOR rates. Finally, our net duration was relatively unchanged and remains relatively low at 111 basis points at the end of the quarter.
Turning to Page 14. MFA's investment and risk management strategy continues to limit quarterly book value fluctuations through various market conditions. Since 2014, the largest quarter-over-quarter decline in book value has been 4%, but the average change in book value of less than 2%.
The primary reason in achieving this has been our strategy of maintaining a low and stable asset duration and our investment strategy that prioritizes assets that derive its return from exposure to credit risk over interest rate risk. As before, we continue to believe that by consistently protecting book value, MFA will have the staying power to take advantage of new opportunities as they arise.
With that, I will turn the call over to Bryan.
Thank you, Gudmundur. Please turn to Page 15. Current state of the economy and housing continue to benefit mortgage credit. However, the rally in rates accelerating an inversion in parts of the yield curve, we are watching economic indicators closely.
Home prices have moderated after several years of outsize growth. CoreLogic National Home Price Index was up 3.6% in May from a year-ago. The unemployment rate continues to hover around historic lows at 3.7% in June and July.
Construction in new homes remained at low level, keeping a cap on housing inventory. Limited supply along with lower mortgage rates will continue to provide support for home prices. The last reported 90 day plus mortgage delinquencies are down to pre-crisis levels around 1%. Given that the credit box for new mortgages is still restrictive along with a prudent underwriting practices, we expect only compete to remain at low levels.
Turning to Page 16. Our loan strategy had another successful quarter of acquisition. We acquired $1 billion of loans consisting of approximately $510 million of Non-QM loan and over $400 million of business purpose loan and $90 million of non-performing loans.
We have seen over $30 billion season loans trade so far in 2019, the bulk being legacy performing and re-performing and less so non-performing. The three performing pools being bid aggressively driving up prices, we became more selective and more successful in adding only one non-performing pool over the quarter.
And our seasoned loan portfolio continues to outperform our expectations at the time of purchase, which I will describe in more detail over the coming slides. And again, as a reminder, our whole loans appear on our balance sheet on two lines, loans at carrying value $4.4 billion loans, loans held at fair value $1.5 billion. This election is permanent and is made at the time of acquisition. Typically, we elect carrying value for a purchased performing loans and re-performing loans and fair value for non-performing loans.
Turning to Page 17. Our RPL portfolio continues to perform well. 87% remained less than 60 days delinquent. In addition, although 13% of the portfolio is 60 days delinquent or greater, almost 30% of those loans have been making payments over the last 12 months. With the recent rally in rates, we are seeing prepayment fees for RPL portfolio increase. With an amortized cost of $0.84 on the dollar, prepayments are positive. We could see elevated prepayment fees as our borrowers gain access to new financing options as a result of improving credit and lower mortgage rates.
Turning to Page 18. We believe our asset management team is best-in-class. The team's oversight of servicing decisions and active management of the portfolio have enhanced returns. The team has worked in concert with our servicing partners to more quickly get loans to reperform as well as limit and reduce time line to resolution. This slide shows the outcomes for loans that were purchased prior to June month end 2018, therefore owned for more than one-year.
35% of loans that were delinquent at purchase are now either performing or paid in full, and 40% are either liquidated or REO to be liquidated. 25% are still in non-performing status. Our modifications have been effective as 78% are either performing or have paid in full. And these results continue to outperform our initial expectations.
Turning to Page 19. We had another successful quarter of growth to our Non-QM portfolio. To-date, we have acquired over $2.1 billion UPB, including of $1 billion this year and continue to work with our origination partners on strategic relationships.
A variety of different loan types can be considered Non-QM, ranging from structural features, such as interest-only period or a term greater than 30 years, to the way income is documented, such as the use of bank statements for self-employed borrowers or loans with higher debt-to-income ratios and so on.
We believe underwriting of these loans is prudent and the portfolio has a weighted-average loan-to-value ratio of 66% and the FICO of over 700. And the credit performance has expected, with 0.8%, six days delinquent or greater. And leverage is attainable through warehouse lines and securitization.
And securitization and execution has improved this year and we expect to securitize should conditions warrant. And with the significant value in rates you’re seeing yield on this assets, trade in the mid-4% range and are able to achieve low double-digit ROEs with appropriate leverage.
And now I'd like to turn the call back over to Gudmundur to walk you through over fix and flip and SFR loans.
Thanks, Bryan. Turning to Page 20. Our acquisitions of business purpose loans continued to grow in the second quarter, as we acquired approximately $450 million in UPB and undrawn commitments in the quarter. Since we started acquiring business purpose loans at the end of 2017, we repurchased over 5,700 loans with over $1.7 billion in UPB and fit about our progress and expect to continue to expand our acquisitions of business purpose loans in the second half of 2019.
At the end of the second quarter, we held approximately $860 million of UPB of fix and flip loans with additional $100 million of undrawn commitments. Credit metrics continue to be strong and performance has been in line with our expectations. Our target yield for this asset-class remains at around 7%.
We held $227 million of SFR loans at the end of the second quarter. Similar to the fix and flip loans, the credit metrics and performance remained strong and in line with expectations. Our target yield for this asset-class remains at around 6%.
With that, I will turn the call over to Craig for some final comments.
Thank you, Gudmundur. In summary, we remain very active in the investment market. We purchased over $1.4 billion of assets in the second quarter of 2019 and grew our portfolio by almost $400 million. This growth in our portfolio has resulted in materially higher interest income over the last two quarters and we expect further such increases as we move forward in 2019. While we have made excellent progress in growing our asset base, we have further capacity to continue to increase our investments by adding modestly to our leverage on our balance sheet.
This concludes our presentation. Operator, will you please open up the call for questions?
[Operator Instructions] Our first question is from Doug Harter with Credit Suisse.
Hey guys. This is actually Josh on for Doug. I was wondering if you could talk a little bit more about the flow agreements that you have. As you've grown the whole loan portfolio specifically, are you continuing to look for partners to enter into flow agreements with? Are you happy with the volumes you're sourcing from the current partners? And then I guess, have you thought about any sort of strategic partnership or equity investments in a mortgage originator like we've seen from some of your peers? Thanks.
Sure. Thanks for the question. So I guess to answer the last part first, we have said that we have been willing to make a minority equity investments for – I think for a competitive reasons, we haven't taken out any billboards about that, but suffice to say, that's part of our repertoire.
In terms of partners, we're always looking for new partners. But that said, we don't really view this as a conduit type of a structure. So I think ideally, it's a handful. It could be 10, 12 partners or so, but it's not 30 or 40. So I think we're very close to all these originators. We've been in their shops, we know the principles, and that's part of what makes us comfortable from a credit standpoint that we think we understand how they look at underwriting and we think we share a similar view with respect to that. So yes, it could increase, but on a modest level.
Thank you. And we'll go to our next question for Eric Hagan with KBW. Please go ahead.
Hey. Thanks guys. Good morning. I know you mentioned that 32% of the repo book is now hedged with swap. So to your point, you'll see that benefit as the Fed cuts shop and funding cost, but how about the asset side, like what percentage of your assets are floating rate that will also presumably reset down as the Fed cuts? Thanks.
Thanks Eric for the question. In terms of the percentage of assets that are floating, we don't have that information in front of us, but what I will say is that, so for example, you could assume obviously the agency arms are floating rate, right. But that's not a significant part of our holdings. Some of the Legacy Non-Agency MBS are floating, but we break that out. For example, on Page 13, we have about $650 million of non-agency fixed rate. The rest would be floating.
As it relates to the MSR-related assets, probably about 50% or 60% of that have floating rate coupons. But in terms of the whole loans portfolio, the new loans we're buying, they either have a fixed rate coupon or they are of a hybrid structure where they're fixed for three, five or seven years, so their coupon is not going to reset anytime soon.
As in terms of the non-performing and re-performing loans, obviously non-performing loans we own, that's more for a credit bet. So whether the coupon that is floating or not, it really doesn't impact the returns on those asset a lot, and the re-performing loans tends to have a fixed rate coupon for a long period of time. So I know that I didn't give you a precise percentage, but hope that helps.
[Operator Instructions] And I have no further questions in queue at this time.
Okay. So thank you for joining us today and for your interest in MFA Financial. We look forward to speaking with everyone next quarter.
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