Cherry Hill Mortgage Investment Corporation (NYSE:CHMI) Q2 2019 Earnings Conference Call August 8, 2019 5:00 PM ET
Rory Rumore - VP ICR
Jay Lown - President and Chief Executive Officer
Julian Evans - Chief Investment Officer
Michael Hutchby - Chief Financial Officer
Conference Call Participants
Tim Hayes - B Riley FBR
Steve Delaney - JMP Securities
Henry Coffey - Wedbush
Greetings. Welcome to the Cherry Hill Mortgage Investment Corporation Second Quarter 2019 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note that this conference is being recorded.
I will now turn the conference over to your host, Rory Rumore, Vice President ICR. Mr. Rumore you may begin.
We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's second quarter 2019 conference call. In addition to this call, we have filed a press release that was distributed earlier this afternoon and posted to the Investor Relations section of our website at www.chmireit.com. On today's call, management's prepared remarks and answers to your questions may contain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ from those discussed today.
Examples of forward looking statements include those related to interest income, financial guidance, IRRs; future expected cash flows, as well as prepayment, and recapture rates, delinquencies, and non-GAAP financial measures such as core and comprehensive income.
Forward-looking statements represent management's current estimates and Cherry Hill assumes no obligation to update any forward-looking statements in the future. We encourage listeners to review the more detailed discussions related to these forward-looking statements contained in the company's filings with the SEC and the definitions contained in the financial presentations available on the company's website.
Today's conference call is hosted by Jay Lown, President and CEO; Julian Evans, our Chief Investment Officer; and Michael Hutchby, our Chief Financial Officer
Now, I will turn the call over to Jay.
Thanks Rory and welcome to today's call. As we have noted in past calls, geopolitical and macroeconomic concerns are largely in control of the market and rate volatility in 2019 is starting to look a lot like 2016. Sharp rise in yields following the surprise Trump election in late 2016 has reversed its tenure yields now revisit the fourth quarter 2016 lows preceding the Trump election.
The 2018 fiscal boost to the economy from the Tax Cuts seems to have run its course and the markets are now driven by anticipated actions of the world's central bankers. This theme also applies to our two asset classes. Prepayment rates on our MBS portfolio have increased quarter-over-quarter going from 5.5% in Q1 to 8.9% in Q2, while prepayments fees on our MSRs have increased from 6.4% for Q1 to 12.5% for Q2.
We are certainly not alone in experiencing the impact from prepayments and unfortunately has been widely felt within the sector. Furthermore, given the size of our MSR portfolio, prepayments naturally have a greater bearing on our results. Prepayments of the underlying loans permanently terminate the related servicing fee income, thereby reducing the earning capacity going forward.
The sequential reduction in core earnings per share to $0.52 is indicative of the initial effects of faster prepayment speeds. We expect that the challenging conditions of Q2 are likely to persist until at least sometime in the fourth quarter when seasonal factors should have a stabilizing effect on prepayment speeds. However, should interest rates continue to decline, the seasonal benefit may not have the same impact as is customary in a more stable market environment.
In light of the market conditions, we continue to hedge the MSR portfolio in order to maintain our duration gap as close to neutral as our model allows. Those changes help moderate the impact in book value from $17.50 for the $16.80 or 4.2% decline net of the dividend from the end of Q1. That strategy remains intact in the third quarter as well.
We have also seen the pace the prepayment speeds carry through into July and now into the first weeks of August. We slowed the growth of our MSR portfolio in the second quarter given that the ongoing push to lower rates. As a result at the end of the second quarter, the MSR portfolio remained at approximately 39% of our equity capital.
Additionally, we continue to be selective in adding to our non-agency MBS investments comprised predominantly of CRT and non-agency jumbo securities that meet our risk/return hurdles. Given our expectation that market conditions will further deteriorate in Q3 and should persist for the remainder of 2019, we expect it at its meeting in September; our Board will set a common dividend policy for the third quarter that is 15% to 20% lower than the second quarter dividend of $0.49 per share subject to any changes in our outlook.
While we expect our funding costs to improve somewhat as lower interest rates work through the expense side of the equation, we believe that a reduced dividend will better reflect our anticipated earnings capacity given current market conditions.
We will remain disciplined in our portfolio construction. Our management team will continue to utilize our collective investment experience, proactively manage our portfolio with the goal of preserving our book value and continuing to generate attractive returns for shareholders. This is a proven and cycle tested team and we believe that longer term, we are positioned to create additional shareholder value over time.
With that, I will turn the call over Julian who will cover more detailed highlights of our investment portfolio and its performance over the quarter.
Thank you, Jay. During the second quarter, global interest rates rallied on global manufacturing weakness, geopolitical concerns and continued rising U.S.-China trade tensions. These concerns increased volatility and lowered global interest rates. Despite increased volatility, a majority of credit sector spreads move tighter and equity indices moved higher as the expectations of greater global central bank intervene pension grew.
Not only was the Fed expected to intervene, but a majority of global central banks are expected to implement some form of policy easing as well as asset purchase programs in the future. Despite global central banks' policy being supportive for spread sector assets and equity indices, the mortgage sector, specifically, RMBS struggle to keep pace given increased volatility, the rally in interest rates, the pronounced inversion of the funding curve versus long-term interest rates, and the expected increase in prepayment speeds.
As a result, RMBS failed to keep pace with treasuries and swaps during the quarter. The mortgage base has widened meaning limited the performance of our book value as investment assets could not keep pace with the Treasury and swap hedges. Over the quarter swap hedges outperformed agency MBS as well as non-agency MBS mortgage securities. On a positive note the price premiums of our spec portfolio increased as rates round, but it too struggled against the deep decline in interest rates. The rally in interest rates also had a negative impact on the market value of our servicing assets.
As shown on slide five, servicing related investments comprised of full MSRs represented approximately 39% of our equity capital and approximately 10% of our investable assets excluding cash at quarter end. Servicing assets were flat as a percentage of equity from the previous quarter as the MSR valuations declined alongside interest rates.
Meanwhile, our RMBS portfolio accounted for approximately 57% of our equity, 5% higher than the previous quarter due to a combination of additional purchases and rising market value during the quarter. As a percentage of investable assets, RMBS represented approximately 90% excluding cash at quarter end.
As of June 30th, we held MSRs with a UPB of approximately $28 billion and a market value of approximately $274 million. Given the falling interest rate environment, we made the decision to slow the rate of additional MSR purchases during the quarter. As we had expected prepayment speeds accelerated considerably during the quarter and have remained high in July and early August, driven by seasonality and lower mortgage rates.
Our conventional MSR and government MSR averaged approximately 12% CPR and 14% CPR, respectively for the second quarter. Conventional MSR speeds were up from 6% CPR in the prior quarter, while the government MSR speeds rose from 9.1 CPR posted during the same timeframe.
As of June 30th, the RMBS portfolio stood at approximately $2.3 billion, approximately 9% higher from the previous quarter as shown on slide seven. Quarter-over-quarter the RMBS portfolio's composition shifted as capital was deployed. The 30-year securities position grew to 80%, up from 78% as of March 31st and the remaining assets represented 20%.
In the second quarter, the collateral composition of the RMBS portfolio posted a weighted average three-month CPR of approximately 8.9%, an increase from the previous quarter as prepayment speeds rose based on seasonality and the lower interest in mortgage rate environment.
On a positive note, the RMBS portfolio's prepayment speeds continue to best Fannie Mae aggregate prepayment speeds. As Jay noted, we expect speeds to remain elevated in the third quarter based upon the persistent lower interest and mortgage rate environment.
For the second quarter, we posted a 0.84% RMBS NIM versus a 1.25% NIM for the first quarter. The NIMs decline was driven by faster prepayment speeds and elevated financing costs versus lower asset yields. Near-term we expect the NIM to fluctuate based upon lower mortgage rates, the seasonality of the housing market, some of which will be offset by lower financing costs, and by the received portion of our swap portfolio.
To improve the NIM, we continue to purchase collateral stories for the RMBS portfolio as well as resetting some of our payer swaps to lower rates. At quarter end, the aggregate portfolio operated with leverage of approximately 5.2 times in a positive duration gap.
We ended the quarter with an aggregate portfolio duration gap of a positive 0.49 years. We maintain a positive duration gap giving continued global trade tensions, weaker global growth, as well as limited clarity from the Fed. The continuous rally in interest and mortgage rates has shortened mortgage durations and thus made the RMBS portfolio only a partial hedge for the MSR portfolio. As we move forward, we will continue to evaluate and alter the portfolio as necessary.
I will now turn the call over to Mike for our second quarter financial discussion.
Thank you, Julian. Our GAAP net loss applicable to common stockholders for the second quarter was $29.3 million or $1.75 per weighted average share outstanding during the quarter. While comprehensive loss attributable to common stockholders which includes the mark-to-market of our held-for-sale RMBS was $4.2 million or $0.25 per share. Our core earnings were $8.7 million or $0.52 per share.
As Jay mentioned, our book value as of June 30th, 2019 was $16.80, a decrease of $0.74 per share from March 31st, 20 19 or 4.2% net of the second quarter dividend. We use a variety of derivative instruments to mitigate the effects of increases in interest rates on a portion of our future repurchase borrowings.
At the end of the second quarter, we held interest rate swaps, swaptions, TBAs and Treasury futures, all of which had a combined notional amount of $2.2 billion.
For GAAP purposes, we have not elected to apply hedge accounting for our interest rate derivatives. And as a result, we would record the change in estimated value as the component of net gain or loss on interest rate derivatives.
Operating expenses were $3.1 million for the quarter, of which approximately $561,000 was related to our taxable REIT subsidiaries. On June 13th, we declared a dividend of $0.49 per common share for the second quarter of 2019, which was paid on July 30th, 2019. We declared a dividend of $0.5125 per share on our 8.2% Series A cumulative Redeemable Preferred Stock, and a dividend of $0.515625 on our 8.25% Series B fixed-to-floating rate cumulative Redeemable Preferred Stock. Both of which were paid on July 15th.
Now, I'd like to turn the call back to Jay.
Thanks Mike. At this time, we'll open up the call for questions. Operator?
At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Tim Hayes from B Riley FBR. Please proceed with your question.
Hey good evening guys. My first question around the dividend cut. Just wondering what exactly this new dividend level reflects? Core earnings has been the proxy for the dividend and is it your expectation that core earnings will also decline by 15% to 20% as soon as 3Q or are we setting the dividend at a level that reflects a longer term view? I know this is a Board decision, but I'm just wondering if there's any insight there and then maybe what payout ratio you'd be targeting.
Hey Tim. How are you? So, I think it reflects what we think we can sustainably earn going forward. And I think as we noted in the second half of the second quarter, we saw prepay speeds elevate meaningfully. And what we're trying to do is not get behind that event.
And I think here what we believe is that faster speeds are here for the foreseeable future relative to where rates are. And it's our expectation that what the Board decides relative to that dividend level is a reflection of what we think we can earn on a go-forward basis in the near-term.
Okay. Understood. And you noted that prepayment speeds remain elevated, but are they -- it's through July and the first week of August, are they in line with your expectations heading into the quarter or they've been -- have they been even faster? Just wondering kind of what is factored into the current MSR market if you expect it to be written down given -- even more in the third quarter given what you've seen? I mean I guess this would be a good time to ask for a quarter-to-date book value update if possible?
No, I think that relative to what we modeled for speeds for the third quarter at least where we see it today, speeds are in line to slightly higher than where we modeled. I think if you pay attention to things like the JPMorgan Prepayment Report, you'll see that speeds are picking up pretty quickly.
If you take a look at what we bought in the MSR portfolio, a lot of the growth in the MSR portfolio was 2018 vintage relative to originations and our view is that that population has the susceptibles to being refinanced. Does that answer that part of the question?
Yes, it did.
The second part of the question is as of July and remember the tenure is clearly slightly different place than it is now probably closer to 2%. We saw book value up in the 1% to 2% range.
Okay. Got it. Thanks for that update. Appreciate that. And then your view for lower earnings is that more a reflection of lower asset yields given the pickup in prepays or how much of that is maybe reinvestment yields given how you're trying to position the portfolio.
I think it’s a combination of the two. But with respect to MSRs as you know as you can imagine we can hedge -- we can do a good job hedging the value. I think us and anybody else invested in the sector would say that it's much harder to hedge the cash flows and with a pickup in speeds as quickly as we've seen them quarter-over-quarter, our expectation is that income as it relates to the degradation around that asset class is has led us to rethink the dividend policy.
Okay. Makes sense. And then I'll ask more of a high level question, excuse me, and then hop back in the queue. But a lot of things are going on that could enhance the role of private capital in the mortgage market, GSE reform, QM patch expiration amongst others. What type of opportunity does that potentially present for you guys given your strategy?
So, if you're referring to -- are we looking to make an investment in originator or it's something like that, today that has not -- that's not something I can tell you that we're far along on.
I think it's a tough discussion. Clearly, somebody like Fannie Mac has an advantage having an established program, but you need to have a fairly robust origination platform to offset some of the prepayments that we think is coming down the pike and for some of our peers who have originators, I don't think they're counting on that part of their operations to protect them more than they are their sub servicing partners.
Okay. Appreciate the comments there Jay. I'll hop back in the queue and potentially follow-up with some more.
Sure. No problem.
Our next question comes from the line of Steve Delaney from JMP Securities. Proceed with your question.
Thanks. Good evening everyone. Jay I know it's been a tough quarter for everybody, we've seen all the big guys cut their dividend 15% to 20%. I think we'll see more of those, so keep your chin up, it's a tough business.
Just a couple -- one question and then maybe just a couple of comments that kind of reflect on where you are today. One, when Julian gave the NIM compression and your opening comments about the CPR increases obviously. But I wanted to know to get down to 84 from a 125 bps, wasn't a relationship of three-month LIBOR to repo also a factor.
We tend to believe that when in AGNC preannounced second quarter dividends that it was not about speed, but it was about that relationship and their cost of funds which they modeled that so much maybe more. But it's hard to predict -- other than seasonal, it was hard to predict this 10-year level. So, just curious if that was in fact also a component of that decline?
I think it's a big component of it. Hi Steve, this is Julian.
Look I mean if you just look at where funding was during the quarter versus where the 10-year treasury or 10-year swaps declined anywhere between 50 to 45 basis points, we saw a decline in the 10-year and 10-year swaps, funding probably only dropped about 10 basis points over that time -- same timeframe.
So you were definitely purchasing assets on what I would kind of call an inverted curve between your funding and where your asset levels that you're putting money to work. That's a very difficult situation.
Yes, I mean it was probably what a negative 20 -- some 25 basis points maybe at the worse and eight times leverage, it adds up. But has that not reversed almost completely not to the point where it's--
I think reversed for maybe a day or two in the new quarter as the Fed obviously did its first ease a while, but then the recent tweets that have been coming out have obviously pushed 10-year yield levels down again.
So, we have a very similar inversion that we had towards the end of the second quarter beginning here in the third quarter. So, a very similar situation. But overall I can tell you that the funding costs are coming down -- slowly coming down not to the same level that we had seen in the past. So, I would definitely say that three-month LIBOR for example we were putting that on probably 2.60 in the second quarter. We have been able to execute around 2.30 to 2.35 into the third quarter.
Okay. Thank you. Yeah. We were hearing somewhat 2.30 handle. And then just switch to the new dividend, I think it's important to kind of put it in perspective. I could do that -- you guys can't necessarily be objective about it I'm going to try to be. So, let's assume the new dividend rounds off to $0.40 just a nice round number, $1.60 a year; your current share price is $16.84; that is a 9.5% dividend yield.
There are not many investment opportunities out there that offer anything like that, especially where we are with everything else in the market down below to below 2%. My thought is -- and you guys are trying to compete in terms of probably between the agency and hybrid, it's 22 companies, there are some big ones when everybody is taken leverage up and it seemed that everybody was trying to work towards an 11% ROE, I don't -- I'm not concerned people were forcing to a yield, but if you want to be competitive, trade well and have access to capital.
I do believe people have been operating with far too much leverage for this business model, okay. Just generally speaking and I think we're going to get more vocal about it because if we look back over the last two years even at the largest companies and with all the manpower, they'll pay you 10% or 11%, but every year they're losing 5% to 7% or 6% or more consistently and that's happened for the last two or three years.
So, any event -- my hope for the business is that people operate with seven to eight times leverage normally and they're happy to pay 9% dividend yields with more stable book values and I think we'd have a much healthier mortgage rate industry. That's just a thought.
But the final thought I want to throw out to you--
Hey Steve, real quick -- just a quick. You used -- to get to 9.8%, you used our book value, but if you looked at our share price, I believe the dividend yield today would be 10.8%.
Okay. Apologies. Yes, I did intentionally do it off-book just to kind of reflect you know the return, but because the stock price can move all around. But -- thank you. So, frankly, that even makes our -- you're still over 10%, right, I mean 13% was -- is crazy in the first place, but I think it just gets to the question of these yields were being -- were driven up because of expectations for cuts. I think they were -- cuts were being priced in when something is trading to 12% or 13%.
So, the last thing is that -- right. So, the last thing that I would just throw out and this has to do with we don't know -- what we have going on right now in the Fed and the trade wars and everything else. I was with a client in Boston yesterday who was absolutely convinced that rates are going to zero and he will not touch credit now. So, he is very interested and the most defensive investments yet. Not, I thought it was a little extreme, but he's smarter guy than I am and has made a lot more money. So, I have to listen to him.
So, my question to you guys as you sit today, complexity is not necessarily a benefit to anybody's model. And I don't think you really do, I mean have a have a complex model, but -- I'm a pose a question is are you an agency REIT or are you a hybrid mortgage REIT and when you came public just because you had this odd thing called MSRs, we necessarily fee-in the hybrid comp table because you were not -- would not have been considered a pure plain vanilla agency, right.
Let me say out of the seven -- right now we have seven agency REIT and 15 hybrid REIT. There are only one or two "pure" everyone is doing something different. I would say that you know in the agency space five of seven have less than 500 market caps and the hybrid space only two of 15 have less than 100.
I guess what I'm saying is I think you guys have strong management. You've operated very well since your IPO generally speaking. And I'm just wondering if presenting your story whether it's agency CMBS or agency MSR is you're in the agency security type of business. And I wonder if positioning yourself as such limiting the complexity of other -- possibly other strategies.
At this point in time when we're going into a high volatility risk-off mode if that might serve you better? So, if you wish to comment on that, fine, if not, I'll just hang-up and leave it on the table, but I just -- I had to share it with you because it's fresh after my meeting yesterday afternoon in Boston.
I think it's insightful relative to just how you think about our sector. Clearly, if you look at the assets that we're invested in there all agency aside from just a small portfolio that is a jumbo way securities, but even the securities -- sort of agency based.
I think we do think ourselves of ourselves as a hybrid relative to just agency MBS given that 40% of the equity is invested in something else. And we have a lot of discussions here about what's the right investment mix relative to exactly what you're discussing, relative to when is the next recession coming? When do I have to worry about credit? Is administration going to push us into a recession?
And so personally I think we have some time, so people who are invested in credit today are definitely benefiting from that relative to the related rates. But I do believe that credit will become an issue at some point and they will have some stress on their business as well. To-date we don't have a meaningful direction towards the credit space.
Understood. It's not something you do lightly without the infrastructure right and the personnel and you're not really in the position to underwrite that additional venture at the current time.
I think it is more about infrastructure. There is an enormous amount of non-agency and credit experience here. And at the right time, I think we could -- but to your point can we get ramped up and will it be enough time to for those returns to be interesting and compelling and enough time to get out when credit becomes a problem. And those are things that we think.
Well, I appreciate your comments and I wish you all the best. Have a good rest of the summer. And hang in there.
We'll all make it through it. Thanks.
Our next question comes from the line of Henry Coffey from Wedbush. Please proceed with your question.
Beauty and the Beast. It's always fun to listen to by my colleague because I think he understands the space as well better than anyone else.
He's signing your tune for lower leverage.
No, I think you're building a better business. I don't think that you're building a good business, you're focused keenly on two asset classes and if I can join the editorial thinking, taking the dividend down, but still offering an acceptable return to investors should not be an issue. And I'll go on for a couple hours on that subject if you'd like. Because -- but we'll leave it at that. It does make for a better business by lowering the dividend and lowering leverage.
And then the question is that as the business evolves to want to dive deeper into where you are or when -- at what point of the equation do we wake up in and find that there's something else going on because your team knows the broader equation fairly well.
And to join some of the other questioners, there is one theory afoot. It's a very bizarre one that the Republicans keep the White House and then when they go into mortgage reforming -- the mortgage market, they put more capital requirements out there. And again that's something that the REITs can do very well.
Yes, I think one thing I think we can agree on is volatility is here to stay for the foreseeable future. And--
Well, if you keep politics out of it, you don't have any explanation for it for a why, but yes, there are some political issues that are certainly scrambling that.
So that keeps it interesting. But I'm trying to be correct there. But we agree at some point continuing to diversify makes sense and to Steve's earlier point one thing you don't want to do is get into something where you might be at the end of a very long good cycle.
So, we try to be thoughtful about how we think about growing or diversifying what we do, meanwhile making sure that we're paying close attention to the assets that we own.
I mean would you start nibbling at an alternative asset classes. I mean if you take on a very small position, it's the best education.
Yes, that's very possible. Likely, I don't know, but possible. We look at diversifying every week when we meet as a group. And the returns have to be compelling. You have to have the expertise in-house to do it. You have to be able to finance it at attractive levels -- without. So, on a risk adjusted return basis which is how I look at life, it has to make sense.
You did -- to your credit, you did talk about this in the last two couple of calls about expectations that the seasonality of CPRs would go the wrong way. You just forgot to mention that we'd be in a 10.7% 10-year.
Yes, I think we've been outperforming -- given our size and given everybody knows our expense ratios, et cetera, we've clearly been outperforming relative to our peers on a consistent basis. You can't do that forever. And yes, we were pretty clear that we expected speeds to normalize in the portfolio.
And if you build around that and you take your dividend -- I mean I'd encourage you to take it down even a little further just because there's no point in paying people some ridiculous yield when we were in a sub 2% 10-year kind of environment.
We're counting on you getting the word out to investors Henry.
Well, they don't listen to me as much as they listen to Steve. So, have them talk to Steve.
Okay, we'll get Steve to do it.
Steve to go out there and put out those tough messages. Well, no, I think it was a great move. So, that's all I have to say.
Well, appreciate the confidence Henry. Thank you.
We have reached the end of the question-and-answer session. And I will now turn the call back over to management for closing remarks.
Great. Thank you. Thank you for joining us on today's call, everyone. We look forward to updating you soon on our third quarter results. Have a great evening.
This concludes today's conference and you may disconnect your lines at this time. Thank you for your participation.