Cherry Hill Mortgage Investment Corporation (NYSE:CHMI) Q1 2023 Earnings Call Transcript May 8, 2023

Operator: Good day, and thank you all for standing by. Welcome to the Cherry Hill Mortgage Investment Corporation’s First Quarter 2023 Conference. . Please be advised that today’s conference is being recorded. I would now like to hand the conference over to our speaker today, Garrett Edson. Please go ahead.

Garrett Edson: We’d like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation’s First Quarter 2023 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.

Jeffrey Lown: Thanks, Garrett, and welcome to our first quarter 2023 earnings call. On our last call, we noted that we remain positioned for additional rate hikes as we awaited word from the Fed as to when the tightening cycle would end, and our efforts to navigate the environment and protect book value were holding up well in the first quarter. Just a couple of days after our call, Silicon Valley Bank suddenly collapsed, with Signature Bank right behind it, sending the U.S. banking sector into a significant crisis that we had not seen since 2008. Nearly overnight after the SVB news, interest rates fell sharply as the markets believe the rate hike cycle was poised to end much sooner than expected and priced in rate cuts in the second half of 2023 in anticipation of economic conditions deteriorating.

Subsequently, the yield curve both steepened meaningfully as short-dated rates fell significantly more than longer-dated rates. We were not positioned for dis immediate violent reaction. And given we were positioned for higher rates, this scenario was where we were most exposed. That, combined with additional spread widening post the bank failures mid-March, negatively impacted our performance for the quarter. In light of the continued banking turmoil, we have maintained a conservative posture towards both our exposure to interest rates and the mortgage basis. We believe the Fed funds rate is approaching the terminal rate, and the banking crisis is largely contained, despite the recent failure of First Republic, and see opportunities in the RMBS sector during the second half 2023.

For the first quarter, while we generated a GAAP net loss applicable to common shareholders of $0.87 per diluted share, we generated earnings available for distribution, or EAD, a non-GAAP financial measure, of $5.2 million or $0.21 per share. While EAD is only one of several factors considered in setting our dividend policy, when we consider the current uncertain environment, we expect that EAD will continue to be pressured in the near term. Given that macro backdrop and subject to Board approval, we expect to realign our dividend in June to a level closer to a yield of 13% to 15% of our current book value. We believe this change will ensure that the dividend is more in line with our current earnings outlook. Book value per common share finished at $5.52 as of March 31, down 8.9% from year-end 2022.

A portion of that decline, as always, is because preferred stock makes up a significant portion of our overall equity profile. On an NAV basis, which includes preferred stock in the calculation, and before taking into account any issuances of equity through our common stock ATM program, we were down 5.3% relative to year-end. We added a slide in this quarter’s investor presentation which describes this impact in more detail. We believe creating a more stable book value profile is in our shareholders’ best interest and remains a top priority for us. We are focused on continuing to navigate through this very challenging and dynamic macro environment. During the first quarter, we essentially stood pat on our MSR portfolio, choosing not to make additional purchases at this time.

Prepayment speeds on our MSR portfolio remain low and thus, the pace of reinvestment to maintain the allocation of capital to the asset class has decelerated. Recapture rates on MSRs were minimal as expected, given the higher interest rate levels. Our portfolio of MSRs has a weighted average note rate less than 3.5%, providing us with significant room to weather rate cuts down the road before impacting our prepay speeds in a meaningful way. We continue to believe our strategy of pairing MSR with Agency RMBS, along with proactive portfolio management and hedging, is the right long-term strategy to steer through this challenging environment. At the end of the quarter, financial leverage rose modestly to 4.4x as we opportunistically deployed additional capital during the quarter.

Given the ongoing market volatility, we believe we remain prudently levered and expect to be further opportunistic in deploying capital in the months ahead. We ended the quarter with $55 million of unrestricted cash on the balance sheet, maintaining a solid liquidity profile. Looking ahead, we will continue to maintain our conservative and proactive approach to portfolio management for the foreseeable future as markets digest macroeconomic data and forecast Central Bank monetary policy actions. Where there are risk-adjusted opportunities to selectively deploy capital, we will take advantage as we did in the prior quarter. Our priority remains to protect book value, and we continue to be mindful of our liquidity and leverage profile. With that, I’ll turn the call over to Julian, who will cover more details regarding our investment portfolio and its performance over the first quarter.

Julian Evans: Thank you, Jay. The first quarter of 2023 can best be described as volatile. The year began on a positive note for mortgages, with interest rates moving lower and mortgage spreads tightening. That lasted until the end of January, and subsequently, mortgage spreads was wider as the investment markets realized inflation was more persistent and that the Fed would need to continue its rate-hiking path. In early March, the U.S. experienced a banking crisis, marked by the twin failures of SVB and Signature Bank, and was marred by the continued struggles of First Republic Bank, amongst other regional banks. Nearly overnight, investor sentiment shifted to believe that the Fed rate hiking cycle was over, and that the investment markets would be experiencing great cuts before the end of the year to minimize possible recession.

No longer would the Fed continue to raise rates through the summer. The Fed is in a tough situation and will have difficult decisions to make this spring headed into the summer. Inflation is lower, but remains elevated and above its target of 2%. While the banking crisis, somewhat contained, has the potential of spreading and tightening credit conditions and thus, reducing growth. These issues may lead the Fed to ending its rate hiking cycle sooner than initially anticipated and may hold rates steady longer than anticipated as the Fed seeks greater clarity on the issues previously mentioned. As a result, we continued to employ a thoughtful hedging strategy in the first quarter. And while the volatility of rates in March impacted book value, we believe we are managing through the environment as best as possible.

Our investment strategy has carried over into the second quarter. At quarter end, our MSR portfolio had a UPB of $21.3 billion and a market value of approximately to $271 million. During the quarter, we made only minimal purchases of new MSRs through our bulk and flow programs. At quarter end, the MSRs and related assets represented approximately 45% of our equity capital and approximately 28% of our investable assets, excluding cash. Meanwhile, our RMBS portfolio accounted for approximately 39% of our equity capital. As a percentage of investable assets, the RMBS portfolio represented approximately 72%, excluding cash at quarter end. During the quarter, we continued to experience CPR improvements in both our MSR and RMBS portfolios. Our MSR portfolio net CPR averaged approximately 4.7% for the quarter, down from 5.4% net CPR in the previous quarter.

The decline was mainly driven by seasonality and the change in mortgage production coupons, which drove slower prepayment speeds for the quarter. The portfolio’s recapture was lowered approximately 1% versus approximately 2% in the fourth quarter. As expected, with current mortgage rate levels, the incentive to refinance is minimal. Moving forward, we continue to expect low recapture rates and a stable net CPR for the foreseeable future given the current levels of interest in mortgage rates. The RMBS portfolio’s prepayment speeds remained low, driven by the combination of new asset purchases as well as the fact that current higher mortgage rate environment is compressing CPRs, the new system proposed. As of today, the majority of the mortgage universe remain out of the model in terms of refinancing.

We would expect prepayments to remain low as long as interest rate levels stay at these levels or higher. For the quarter, the RMBS portfolio’s weighted average 3-month CPR reduced to approximately 3% compared to approximately 3.8% in the fourth quarter. As of March 31, the RMBS portfolio, inclusive of TBAs, stood approximately $709 million compared to $646 million in the previous quarter. Quarter-over-quarter, the spec pool portion of the portfolio continued to grow as we opportunistically put new cash to work as well as converting a few dollar rolls into pools as dollar rolls weaken further. We also continue to proactively change the portfolio’s composition. At the end of the first quarter, 30-year securities position represented 100% of the RMBS portfolio.

For the first quarter, our RMBS net interest spread was 3.41%, driven in part by having a larger portfolio and by having more securities on repo. At quarter end, the portfolio’s financial leverage stood at approximately 4.4x. Looking forward, we remain mindful of the continuing uncertain environment and await further clarity from the Fed regarding the terminal rate. I will now turn the call over to Mike for our first quarter financial discussion.

Michael Hutchby: Thank you, Julian. Our GAAP net loss applicable to common stockholders for the first quarter was $21.4 million or $0.87 per weighted average diluted share outstanding during the quarter. While comprehensive loss attributable to common stockholders, which includes the March market of our available for sale RMBS, was $7.1 million or $0.29 per weighted average diluted share. Our earnings available for distribution attributable to common stockholders were $5.2 million or $0.21 per share. Our book value per common share as of March 31 was $5.52 compared to a book of $6.06 as of December 31, 2022. 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 first quarter, we held interest rate swaps, TBAs and treasury futures, all of which had a combined notional amount of $1.1 billion. You can see more details with respect to our hedging strategy in our 10-Q as well as in our first quarter presentation. For GAAP purposes, we have 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 $3.2 million for the quarter. On March 16, the Board of Directors declared a dividend of $0.27 per common share for the first quarter of 2023, which was paid in cash on April 25, 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 April 17, 2023.

At this time, we will open up the call for questions. Operator?

Q&A Session

Operator: . Our first question comes from the line of Mikhail Goberman of JMP Securities.

Mikhail Goberman: I appreciate the color on the dividend going forward. A quick question for you. Just wanted to get your thoughts on hypothetic scenario. Lots of reports coming out that the banking industry is going to have to strongly decrease its duration in your portfolios, and that could end up having a pretty severe effect on MBS purchases as a marginal buyer. Just wanted to get your thoughts on how you see that potentially playing out going forward with spreads? And also kind of piggyback on that, if that were to develop, how do you guys think about the relationship between MSRs and MBS in that environment?

Julian Evans: Mikhail, it’s Julian. As for sales of MBS, obviously, we have started to experience some sales through the FDIC. At the moment, those have gone pretty well in terms of selling some of the securities that were in SVB’s portfolio. On a going-forward basis, it would not surprise me that banks themselves kind of pull back a little bit on purchases of RMBS securities. I’m not expecting them to be a big buyer as we move forward. And as such, yes, mortgage spreads have tightened in over the past couple of days, but we could see them kind of being volatile for the rest of the year, whether that be tightening in several days a week and then widening out several days a week. And as a result, we’re also keeping our powder dry and also trying to keep our leverage on the lower hand side of things.

This market, we expect, as I mentioned, from a technical standpoint, the buyers of mortgages are just not going to be the buyers that we’ve had in the past. The Fed is not buying. The GSEs are not buying. And as mentioned, I think the banks will be limited in terms of the purchases that they are doing. And I’ll turn it over to Jay if he wants to make some comments on MSR as well as RMBS.

Jeffrey Lown: So I think the important thing to note on the MSR portfolio is from a spread perspective, we’ve pointed out over the years that it definitely does a better job of protecting with current coupon. And as I noted in the speech, our coupon — or our note rate on the mortgages is in the mid-3s. And so by definition, it will protect less relative to a spread widening on the MBS. But clearly, to some extent, just less. And I think that’s true for anybody who holds a large portfolio of MSRs that were originated pre-2023.

Mikhail Goberman: Got it. Appreciate that color. And could you guys give an update on book value thus far this quarter.

Michael Hutchby: Mikhail, it’s Mike. Yes. At April 30, we estimate that our book value per share is down about 3%, and that’s before any dividend accrual as the Board has not yet met to approve a dividend for the quarter.

Operator: Our next question comes from Matthew Howlett of B. Riley.

Matthew Howlett: First, on the higher coupons. I mean, you mentioned, obviously, I mean, March surprised sort of everybody. Is the bias still towards the higher coupons here today? I noticed the yield came down a little bit on the MBS side. Was that because of sort of higher prepayment rates assumptions? Just walk me through where in the stack you want to be, and what was the impact of the first quarter on an NII basis?

Julian Evans: Matt, it’s Julian again. Let’s just start with like portfolio in terms of coupon selection. The primary coupon that we like in the portfolio is 30-year 5s in the portfolio. So slightly below par kind of on a discounted basis you can get that particular coupon. And kind of the coupons that kind of surround that a little bit, 5.5s as well as 4.5s, we’ve been buying those for the portfolio over the time frame. Now clearly, if the Fed is changing its posture and thinks that it needs to lower rates within the coming year, I think that there will suddenly be a shift — slowly be a shift into perhaps some lower coupons. We are keeping powder dry. They were cheap. They’ve — partially driven by the fact that there were going to be security sales that we all knew that were going to be coming out by the FDIC in terms of some of the bank portfolios.

Those sales have actually gone pretty well, and we’ve seen lower coupons trade pretty well. We still think the Fed has got a goal here to accomplish in terms of inflation. We think it will be more persistent than what a lot of investors are kind of thinking. We think that the Fed is not going to cut rates this particular year. If that were to change, or prior to that changing, we have looked into the valuations of lower-coupon securities. We still own some 3s as well as 3.5s in our portfolio. But we would begin to take that up in size if — towards the end of the year, I believe, as the Fed may be changing its posture at that point in time. As for the NIM, part of the NIM was driven by the fact that some additional securities went on repo. And quarter-over-quarter, there were a couple of securities that had yet to be put on repo and that kind of decreased our overall NIM in the quarter.

Matthew Howlett: Got you. Makes a lot of sense. I guess just a follow on. I guess the second question is just — I mean, we look at the debt ceiling. How do you — I guess a quick question is, how are you positioning for an event — for some unlikely event of default or that? I mean is there any sort of color you can give us on how you could position going into June?

Julian Evans: Well, let’s say, post March 8, we have started to position the portfolio much more conservatively. Prior to that, the expectation was the Fed was going to continue at a rate path of possibly 2 to 3 more hikes in the year and possibly getting a terminal Fed funds rate of 6%. We’re not under the belief that they can’t get at least 1 more hike this year, but let’s just say that’s not possible and they hold out for the end of the year. The debt ceiling obviously, is somewhat of a concern and kind of ironically, as you’re saying, the fact that the U.S. can’t pay its debt, people tend to buy the debt. So we’re not trying to take any real positioning. We’re trying to smooth out our positioning on the curve as well as our duration.

Matthew Howlett: Look, that makes a lot of sense. And I’m expecting obviously — you’re not expecting any disruption in the repo market or that mean that you kind of put — your haircuts look flat and then you’re still good in the repo market?

Julian Evans: We have found liquidity to be very good in the repo market. I think all you have to do is look at the Fed’s repo facility, and you’ve got $2.5 trillion sitting there. People had cash that they would like to put to work. We have access to repo, that has not changed.

Matthew Howlett: Great. And then last question, I look at you guys, and you’ve done a really commendable job getting through these rate hikes with the MSRs and I like that slide in terms of the preferred now showing the impact, the leverage of the common, the greater the impact that it’s had on you guys, and you guys have really defended it really well, and hopefully, it starts working on the other end. With the rightsizing of the dividend, when you look at the company in the next stage of growth, let’s say the Fed does stop here or at some point, begin cutting and you get all these MBS coming out spreads. If you look at the company, I know you want to grow it. Would you look at moving towards a much bigger RMBS portfolio over time in MSRs that was sort of a great hedge to have on during this rising rate environment.

And that you could really — you have a lot of dry powder. But if you even let the MSRs run off more, even sell them, we could even have a bigger balance sheet going into next and the leg of the cycle. Just talk to me about where — with this dividend reset, I mean, where do you see the company going, Jay, the next part of the cycle, assuming that we’re close to the end of this one.

Jeffrey Lown: Yes, I’m happy to do that, Matt. So I think there’s a value conversation relative to just rates. Wells Fargo and others have put out a fairly significant amount of servicing this year so far. And the expectation is that should continue for some time. And so we have seen some relief, if you will, in pricing around servicing. So as much as you think about rates, you think about pricing and yield. And so as we look at the MSR space and the amount of capital that we want to allocate to it, especially in a scenario that you pointed out, which is a growth scenario. I think we’ll be looking at a few things, which is one what’s the optimal mix between the 2 strategies that we think makes sense from an equity capital perspective, and then also from a yield perspective as well.

I think there’s a view on our side that any relief in rates will primarily come from the front end of the curve and the back end of the curve might be less volatile over the near term, if you will. And so from that perspective, we think that the MSR continues to present and represent a pretty good investment alternative for us. It becomes a conversation about returns and the amount of absolute capital that you’d like to deploy into the sector. So we think that once the Fed starts cutting, that is predominantly a front end of the curve phenomenon, which should provide some relief to the MBS returns, but we won’t take away from the MSR returns. And by the way, one of the reasons I mentioned the note rate on the in the script was because I just want to point out that we are — we have so much runway left with this portfolio relative to what really matters, and that speeds.

And so to the extent that speeds are managed, we can manage through the pricing aspect of it from a rates perspective, but we feel really confident about the ability for the portfolio to perform from a prepayment perspective. Does that help?

Matthew Howlett: It helps tremendously. I mean you’d have to see mortgage rates, I mean, go I mean below 3 and I mean do you have the CEO met some pre-COVID level, right, to even put any of those in the money to refinance.

Jeffrey Lown: Right. While my kids are very hopeful that might happen, I’m less optimistic for them.

Operator: Thank you. I’d like to turn it now back to Jay for closing remarks.

Jeffrey Lown: Thanks, operator. Thank you very much for joining us on today’s call. We look forward to updating you soon on our second quarter results. Have a good evening.

Operator: Thank you for your participation in today’s conference. This does conclude the program, and you may now disconnect. Thank you, everyone. Sorry about the hiccup with the recording. We did recover, but I appreciate your grace and patience in that and wish you a great evening. I will now end at the conference.