Cherry Hill Mortgage Investment Corporation (NYSE:CHMI) Q2 2022 Earnings Conference Call August 3, 2022 5:00 PM ET
Company Participants
Garrett Edson – Managing Director, ICR
Jay Lown – President & Chief Executive Officer
Julian Evans – Chief Investment Officer
Michael Hutchby – Chief Financial Officer
Conference Call Participants
Henry Coffey – Wedbush
Mikhail Goberman – JMP Securities
Matthew Howlett – B. Riley
Operator
Thank you for standing by. My name is Cheryl, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cherry Hill Mortgage Investment Corporation Second Quarter 2022 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.
Garrett Edson, you may begin your conference.
Garrett Edson
We’d like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation’s second quarter 2022 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 earnings available for distribution or EAD, 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, the Chief Investment Officer; and Michael Hutchby, the Chief Financial Officer.
Now, I will turn the call over to Jay.
Jay Lown
Thanks, Garrett, and welcome to today’s call. The entire mortgage REIT sector was impacted by numerous macro and geopolitical concerns in the second quarter. In addition, the Fed turned aggressively hawkish to combat inflation as anticipated and hiked rates twice during the quarter, 50 basis points in May and 75 basis points in June. Last week, we navigated yet another 75 basis point hike.
We continue to believe the Fed will remain aggressive with respect to tightening monetary policy in the near term, given their focus on bringing inflation down towards their target levels.
In response, the US 10-year treasury rose to 3.5% by mid-June, and we were positioned well for the higher rate environment. However, recession fears gripped markets towards the end of June, leading to a rally in rates that continued through July.
This, coupled with mortgage spreads widening during the quarter, most meaningfully at the end of June, negatively impacted our book value for the quarter. Ultimately, the US 10-year treasury finished the quarter at 3.02%, 68 basis points above its closing level at March 31.
Our portfolio strategy has remained intact, pairing MSR with Agency MBS. We are constructive on agency mortgage spreads, given the significant widening this year and believe our positioning there has had a positive impact on performance year-to-date.
We continue to actively adjust our investment portfolio to protect the business and remain less levered relative to historic norms in this dynamic macro environment to preserve book value. Julian will provide more details on our efforts shortly.
For the quarter, improving prepayment speeds continue to aid our earnings available for distribution, or EAD, a non-GAAP financial measure. For the second quarter, we generated a GAAP net loss applicable to common stockholders of $17.6 million or $0.92 per diluted share, and we generated EAD of $5.2 million or $0.28 per share, exceeding our quarterly common dividend level of $0.27 per share.
On an annualized basis, our dividend yield is hovering in the mid-teens based on the recent average of our closing price of our common stock. Importantly, EAD is just one of several factors we consider in setting our dividend policy. Book value per common share finished at $6.73 as of June 30. As a reminder, our current book value performance per common share is a function of preferred stock making up a significant portion of our overall equity profile.
On a net asset value basis, which doesn’t account for the difference in common or preferred equity. Our performance in the quarter was more effective with NAV down approximately 4% quarter-over-quarter before taking into account any common stock issuances pursuant to our ATM program. We believe our NAV performance demonstrates that the actions we took during the first half of the year, along with our strategy of pairing RMBS with agency MSRs, contributed to mitigating risk and moderating the full impact of spread widening in Agency RMBS.
That said, we remain committed to stabilizing and growing our NAV and book value as we move ahead. We continue to believe the best approach to adding to our MSR portfolio is remaining selective given the macro environment, the competition and robust pricing. During the second quarter, we acquired approximately $950 million UPB in MSRs by a flow in both purchases. As we’ve said before, we continue to believe the strategy of marrying MSR with Agency MBS provides for attractive risk-adjusted returns and aids in protecting the portfolio from the full extent of current coupon spread widening.
At the end of the quarter, leverage was 3.4 times, and lower than the prior quarter as we remain mindful of the heightened market volatility in our current environment. We ended the quarter with $62 million of unrestricted cash on the balance sheet, maintaining a solid liquidity profile. Our recapture efforts remain solid with a 12.1% recapture rate on our MSRs in the quarter despite the rise in mortgage rates. That said, recapture rates should continue to decline at these higher levels. Though prepayment speeds, net of recapture should continue to remain low.
Looking ahead, we will continue to closely monitor MBS spreads and at the appropriate time, we will look to raise our leverage toward more normalized levels. Our proactive decision to derisk the portfolio and sell securities helped mitigate the impacts of the rising rates and spread widening during the first half of 2022. We remain positioned for a bias towards further Fed tightening of monetary policy and a high rate environment for the foreseeable future as the economy tackles the highest inflation it has seen in over 40 years. In the meantime, we are keeping a firm on our balance sheet. And when we see attractive investment opportunities, we will continue to selectively invest.
With that, I will turn the call over to Julian, who will cover more details regarding our investment portfolio and its performance over the second quarter.
Julian Evans
Thank you, Jay. As Jay noted, the second quarter remarks by a rapid rise in interest rates as the Fed work to combat escalating inflation levels, including executing the first 75 basis point hike in nearly 30 years. The quarter also marked the start of the Fed outlining a plan and working to reduce its balance sheet. Throughout the quarter, we positioned our portfolio for a rising rate environment as the US tenure rate rose to nearly 3.5 by the middle of June. Just as quickly, US tenure fell in the final two weeks of the quarter and continue to move lower in July, despite the Fed hiking defense funds rate, another 75 basis points for a second consecutive month.
The market continues to attempt to put run the Fed. And for now, seems to believe 3.5 is the ceiling for Fed funds, but until inflation appears to retain, the Fed will likely need to continue hiking rates, which may lead to a hard landing as the Fed tries to precariously balance curbing inflation without sinking the economy.
At quarter end, our MSR portfolio had a UPB of $21 billion approximately. And a market value of approximately $264 million. During the quarter, we purchased approximately $950 million UPB of new MSRs through our bulk and flow programs. At the end of the second quarter, the MSR portfolio represented approximately 40% of our equity capital and approximately 24% of our investable assets, excluding cash.
Meanwhile, our RMBS portfolio accounted for approximately 40% of our equity. As a percentage of investable assets, the RMBS portfolio represented approximately 76% excluding cash at quarter end. During the quarter, we continued to experience CPR improvements in both our MSR and RMBS portfolios.
Our MSR portfolio’s net average CPR approximately 10% and for the second quarter, down from approximately 13% net CPR in the previous quarter. The decline was mainly driven by the continued rapid rise in interest rates and the change in mortgage production coupons, which drove slower prepayment fees in the quarter. The portfolio’s recapture rate was lower at 12% versus 20% in the first quarter, which is expected if interest in mortgage rates rose, making the incentive to refinance less.
Going forward, we should continue to expect a lower recapture rate, but stable or improving net CPRs and given the elevated levels of interest and mortgage rates. The RMBS portfolio’s prepayment fees exhibited similar games, the portfolio’s weighted average three-months CPR reduced to approximately 7% for the second quarter compared to approximately 11% in the first quarter.
As rates move higher, mortgage securities became less refinanceable. As of today, the majority of the mortgage universe is out of the money in terms of refinancing. We would expect repayments to remain low as long as rates stay at these levels or move higher. As of June 30, the RMBS portfolio inclusive of TBA stood at approximately $831 million, compared to $941 million at the previous quarter end. The portfolio reduction was driven by the selling of securities, rising interest rates as well as mortgage spread widening.
Quarter-over-quarter, the size of the RMBS portfolio was reduced to lower basis risk and to protect book value as interest rates rose. In addition to reducing the size of the RMBS portfolio, we changed the portfolio’s composition, moving into higher coupons, reducing spread duration for the portfolio.
In addition, we took the opportunity to improve yields for the portfolio in the quarter. At the end of the second quarter, the 30-year securities position represented 93% of our RMBS portfolio, a similar percentage to the end of the first quarter. Shorter duration securities made up 7% of the portfolio at quarter end. For the second quarter, we posted a 3.46% RMBS net interest spread versus a 3.06% net interest spread reported for the first quarter, driven by higher yields as we reposition the portfolio, coupled with the combination of better prepayment speeds.
The spread was also aided by lower net interest expenses due to our payer swaps at three-month LIBOR and SOFR reset to higher loans, which minimized the effects of higher repo costs. At quarter end, the portfolio leverage stood approximately 3.4 times at the aggregate level, and the portfolio was managed with a negative duration gap.
Looking forward, we remain cautious, and we expect the investment markets to remain volatile and operate with limited liquidity. The Fed verbally remains committed to bringing inflation down from a 40-year high.
Last week, the Fed raised the Fed funds rate, and we expect them to raise the Fed funds rate further in fiscal year 2022. Despite its efforts, inflation remain at elevated levels. Over the next several weeks, battle in the markets will be weighed between the Fed’s commitment to inflation fighting and an economic slowdown possible recession.
Current markets are implying that the Fed will be able to handle inflation would give way to a pending recession in 2023 and start the process of easing monetary policy. The investment markets are attempting to front run, we’re anticipating a Fed pivot assuming the Fed will either moderate the size or the pace of the Fed funds increases as well as never reach the upper side of its range. We expect the economy to slow, but that the feds remain committed to lowering inflation as inflation remains solidly above its target of 2%.
I will now turn the call over to Mike for our second quarter financial discussion.
Michael Hutchby
Thank you, Julian. Our GAAP net loss applicable to common stockholders for the second quarter was $17.6 million or $0.92 per weighted average diluted 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 $5 million or $0.26 per weighted average diluted share.
Our earnings available for distribution attributable to common stockholders were $5.2 million or $0.28 per share. Our book value per common share as of June 30 was $6.73 and compared to a book value of $7.27 as of March 31, 2021.
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, TBAs and treasury futures, all of which had a combined notional amount of $1.3 billion. You can see more details with respect to our hedging strategy in our 10-Q as well in our second quarter presentation.
For GAAP purposes, we’ve not elected to apply hedge accounting for our interest rate derivatives. And as a result, we record the change in estimated fair value as a component of the net gain or loss on interest rate derivatives.
Operating expenses were $3.1 million for the quarter. On June 17, 2022, our Board of Directors declared a dividend of $0.27 per common share for the second quarter of 2022, which was paid in cash on July 26, 2022. We also 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 15, 2022.
At this time, we will open up the call for questions. Operator?
Question-and-Answer Session
Operator
[Operator Instructions] Your first question is from Henry Coffey of Wedbush. Please go ahead. Your line is open.
Henry Coffey
Yeah. Good afternoon and thank you for taking my question. How do market conditions today compared to where they were at the end of June, when we saw all these marks. I mean, had things calm down a little bit, have spreads narrowed, are they widening? What is the general – how do we compare today from – to June 30?
Julian Evans
Hi, Henry, this is Julian. If it’s just in terms of like mortgage spreads, it’s been evolved for a couple of days since – well, I guess, since the end of – if you want to go since the end of June, they’ve tightened in pretty reasonably. I would say, maybe 15 to 20 basis points tightening in to the end of July. And post July, we are fluctuating around. So, yesterday were wider. Today, they’re tighter. So call it relatively flat for the start of August here. But from a net – go ahead.
Henry Coffey
I’m sorry, I’m sorry, keep going.
Julian Evans
Well, from a spread perspective, RMBS is tighter from the end of June.
Henry Coffey
So should we expect to see positive fair value marks coming through or more of what we’ve seen in the last two quarters?
Jay Lown
Are you talking about company-wide Henry, or are you just talking about RMBS?
Henry Coffey
Both, both, I mean, obviously, we’ve had a couple of other REITs report, so we understand what’s going on so.
Jay Lown
Yeah. Sure. Mike, do you want to give Henry a –
Michael Hutchby
Yeah. Through July 31, we see book value per share up about 2%. And that is, of course, excluding any accrual for the – for a dividend as the board has not yet met to approve a dividend for the quarter.
Henry Coffey
All right. Thank you
Operator
Your next question is from Mikhail Goberman of JMP Securities. Please go ahead. Your line is open.
Mikhail Goberman
Hi. Good afternoon, gentlemen. Hope everybody is well. Quick 2-parter from me. Could you guys talk maybe for a little bit about how you see the Agency RMBS versus MSR pair off trade working from a capital allocation standpoint going forward? And also, is there any appetite to maybe tick up leverage from this point on? Thanks.
Jay Lown
Sure. So to the first question, which I think was how do we think about the allocation of capital relative to the percentage of equity to each strategy. I think one of the things that we’ve done, as you know we’ve taken down leverage on the RMBS side throughout the year, just given our view on where spreads could go and some of the volatility in the space as rates back up, what I think we would call meaningfully through the quarter.
And during that process, speeds for the MSR portfolio have remained low. So the desire to grow that portfolio versus maintain the size, I would tell you that we have chosen to more maintain the size of the portfolio and the percentage of equity in each asset class.
I think, primarily one, because of the — what I would call, just the MSR market being a little bit on the rich side today, relative to where we think the value is in terms of the newer production. And our view that we think that spreads should normalize on the RMBS side, and we would look to increase our activities on that side of the house.
Mikhail Goberman
Got it. Thank for that.
Jay Lown
As it relates to the leverage question, I think we have a view that spreads are starting to normalize. I think you’ve heard other people say the same, and we’ve seen some people raise capital with the intention of deploying capital into the agency space. We are constructive on the RMBS space today. We think that there’s value there. But we are very mindful of the volatility day-to-day in the market, relative to all things, geopolitical, macroeconomic and anything related to what the Fed may or may not say on any given day.
Mikhail Goberman
Thanks, Jay.
Jay Lown
Sure.
Operator
Your next question is from Matthew Howlett of B. Riley. Please go ahead. Your line is open.
Matthew Howlett
Hey, Jay. Thanks for taking my question.
Jay Lown
Hi, Matt.
Matthew Howlett
In terms of MSR valuation, I mean at this point, maybe do MSR values can they keep going up, or do they just sort of have — they only kind of go one way from merit. And then, what’s the — once services talk about escrows, I’m assuming you get the escrows on the MSRs. I mean what’s — is that going to have an impact if federal funds goes — continues going higher?
Jay Lown
So, I’ll take the last part first. Escrows are a component of the valuation. And clearly, as rates rise, that becomes a more — a larger part of the valuation. And we are very focused on that relative to how we think about the MSR valuation in the aggregate. So I would say that they become a more meaningful impact to the valuation versus rates — versus a 10-year 50 basis points sure or Fed funds at zero. So yes, as rates rise, those become a larger portion of the valuation of the asset class.
The first part of your question is probably a little bit more involved, because that really depends on the collateral composition of the portfolio. If your portfolio was largely lower coupon MSRs, then I think clearly, what we’ve seen as rates rise, the benefit and the correlation to assets, sort of, stabilizes and it becomes less correlated. But I think as you add more MSRs at a more current coupon, those assets clearly can rise and fall just purely based up being more in the money.
So does that answer your question somewhat? Our portfolio today is somewhat barbell. So we have a portion of the portfolio at, let’s just say, 3.25% and below and a portion of the portfolio that we probably see at 3.75% and above. There really wasn’t a lot for us in the 3.25% to 3.75%. So from that perspective, there is room for the portfolio of growing value, but again, not so much in the lower coupons.
Matthew Howlett
Got you. No, that’s very helpful. And then I heard your comments about the market is still volatile, and you want to keep some dry powder. How much of this — I didn’t hear you make any comments in terms of the Fed. Do you feel — do you believe the Fed will start selling MBS. I mean, it’s been slow to start running it off. I mean, how much is that going to have an impact? Do you think that we could go a lot wider, is that what you’re waiting for, if they do start selling?
Jay Lown
Yeah. So that’s a really good question. And I think, broadly speaking, I think our performance during the quarter was better than a lot of agency guys in part, because we divested a lot of the lower coupon MBS throughout the quarter early on in anticipation of a potential spread widening more heavily in the lower coupon stack. I think others may have held on, and they got hit in the second quarter and got a bigger benefit in the third quarter. But we definitely repositioned ourselves more out of the lower coupon stack — part of the coupon stack, because of a fear that if the Fed does start to sell, they are the primary holder of this stuff and could materially impact spreads on the lower coupon MBS. And while we don’t have a strong view either way that they’re going to sell, or just let it run off. Our view was that we weren’t really interested in managing that risk. And hence, I think you see a slightly or a more stable profile relative to the book value in that side of the house because of that, do you think that accurately describes it, Julian?
Julian Evans
Yeah, I think so.
Matthew Howlett
No, that makes — it’s definitely smart repositioning. The books held up a lot better than peers. I guess the last comment is on like you said Cherry Hill did this big because you have a little bit more preferred, you’ve got to get this base snapback in book. I think you said 50 bps of the basis tightening the book could go to like $8 or $9 — back to $8 or $9. But at the same time, you probably really like the wide spreads. You don’t really want to see the basis tightens.
So, to investors just think about — we just think about getting high returns, high cash flows using low leverage and just sort of just enjoy that part of it instead of just sort of waiting for spreads to tighten. I mean sort of — do you feel like this is now a time to really begin growing again given where spreads are and how well you’re positioned for the rate environment?
Jay Lown
So, I would say that clearly, we’re at wide for a lot of coupon spread wise. I think that that is — it’s not as easy to just say that on a broad level because of who owns certain coupons and where we think a more historical norm is for the spreads in that part of the coupon stack.
But I would say that we do expect to pick up leverage at some point, and we feel good about having taken it down thus far and are looking for good opportunities to grow the RMBS portfolio as we feel things sort of get to a point that’s more normalized from a historical level. Julian, do you have anything you want to add to that?
Julian Evans
Yes, I think the main thing is, I think you’re looking for some stability in rates. I mean every day, we’ve moved probably half a point to a full point which equates to six basis points to 12 basis points a day. So, I think what we’re looking for is a little bit of stability and I don’t think that’s truly played out in the markets.
What we’ve seen, at least in the third part of the third quarter, you’ve had lower coupon mortgages outperformed given the flattening or kind of the inverted the continued invertedness of the curve that’s taken place and higher coupons have actually lagged in the spread tightening.
So, I think in general, we can get some stability and we take up the leverage, we put more money to work. But I think that we’ve got to get more stability out of the Fed. The Fed is obviously this week stated they’ve got very much committed to raising interest rates or Fed fund rates to getting them to a level that’s much more restricted in the economy.
And I think this goes back to the last paragraph that I kind of talked about it says at the end of the day, there’s going to be this fight over the next couple of months. And it comes down to — is there going to be a recession, or are we going to have a soft landing and the fact, it’s going to be able to achieve what it wants to do on the Fed funds rate side.
Matthew Howlett
Got you. Well, look, I mean, returns are just phenomenal for the leverage commonly using. So, to think that they could get better is something that’s really open. But I appreciate the patience and thanks for your comments.
Jay Lown
Thanks, Matt.
Operator
We have completed the allotted time for questions. I will now turn the call over to Jay Lown for closing remarks.
Jay Lown
Thanks, everyone, for joining us on our second quarter 2022 call and we look forward to updating you in a couple of months for our third quarter results. Have a great evening.
Operator
This concludes today’s conference call. Thank you for your participation. You may now disconnect.
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