MFA Financial, Inc. (NYSE:MFA) Q4 2022 Earnings Call Transcript

MFA Financial, Inc. (NYSE:MFA) Q4 2022 Earnings Call Transcript February 23, 2023

Operator: Ladies and gentlemen, thank you for standing by and welcome to the MFA Financial Announcement Fourth Quarter 2022 Earnings Call. As a reminder, today’s conference is being recorded. I would now like to turn the conference over to our host, Harold Schwartz.

Harold Schwartz: Thank you, operator and 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 as to 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 — 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, 2021 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 fourth quarter 2022 financial results. Thank you for your time. I would now like to turn this call over to MFA’s CEO and President, Craig Knutson.

Craig Knutson: Thank you, Harold. Good morning, everyone and thank you for joining us here today for MFA Financial fourth quarter 2022 earnings call. Also with me today are Stephen Yarad, our CFO; Gudmundur Kristjansson; and Bryan Wulfsohn, our Co-Chief Investment Officers and other members of senior management. The fourth quarter of 2022 was yet another wild ride to punctuate what was one of the most difficult years ever for fixed income and for the mortgage market, in particular. Rates ended the fourth quarter only slightly higher than they were at September 30 but the path is anything but straight. 2-year treasuries began the fourth quarter at 428 and sold off to 472 in early November before rallying back to close out the year at 443.

After beginning the quarter at 383, 10-year treasuries hit a high for the year of 424 in late October before rallying back in the year almost unchanged at 387. This volatility in the rates market weak the mortgage market with agency mortgages widening out in late October to the widest level since the great financial crisis. RMBS securitization markets, while technically not closed, were quite dysfunctional, with AAA cash flows widening even more than Agency MBS spreads. As breathtakingly bad as 2022 was for fixed income and mortgage participants, it was not a total surprise to us at MSA. On our fourth quarter 2021 earnings call a year ago, I stated that we expected ongoing rate volatility with inflation ranging at the time, the Fed on the move and a tense geopolitical environment.

For our first quarter 2022 earnings call, I remarked how similar 2022 felt to 1994 when the Fed raised rates 6x for a total of 250 basis points. Now we certainly did not have a perfect crystal ball but we began preparing from 2022 in late 2021 and we took additional steps early in 2022 to prepare for higher rates. As market expectations changed in 2022, we took further action to protect MFA for market forces. We had $900 million of interest rate swaps on at year-end 2021. And this is when market expectations, by the way, were for 325 basis point Fed funds increases during 2022. It seems like a long time ago. We increased our swap book to $2.4 billion by the end of the first quarter of 2022 and to $3.2 billion by the end of May. At the same time, we continue to execute securitizations throughout the year despite higher rates and higher spreads on the rated securities that we sold.

There were numerous occasions during the year when we priced the securitization and we were somewhat disappointed with our execution in a week or 2 later ecstatic that we had printed the deal when we did. The securitizations complemented our interest rate swap positions by effectively fixing our future funding costs and, at the same time, reduced our exposure to margin calls on repo and warehouse funding. Our management of MFA’s funding cost is historically evident when you look at our cost of funds, particularly in the fourth quarter of 2022. We stated on our third quarter earnings call that 99% of our asset-based financing costs were effectively fixed either through securitizations or interest rate swaps. Our cost of funds in the fourth quarter was 3.7% which is only 10 basis points more than it was in the third quarter.

And this despite the fact that the Fed raised rates, 125 basis points in the fourth quarter and 200 basis points since their meeting in September. Many others in our space saw funding costs increase by 100 basis points or more in the fourth quarter. And in fact, our funding costs were only 32 basis points higher in the fourth quarter than they were in the second quarter and the Fed raised rates by 350 basis points between June ’16 and December 31. As a result of when we entered into our interest rate swaps, our weighted average fixed pay rate was 169 at December 31. Given the current level of SFR, our interest rate swap book now generates a positive carry of close to 300 basis points and this positive carry will increase further as Fed funds rates increase further.

Finally, we added — as we added assets at increasingly higher yield, our net interest spread has increased in both of the last 2 quarters. Our book value was down very modestly in the fourth quarter and was down a little over 20% for the year and our economic return for the year was down 13% on GAAP and 16% on economic book value. While this is a disappointing result for MFA, our proactive hedging and liability management, limited the book value decline as some others saw declines in book value for the year of between 30% and 50% and economic returns for the year down 25% to 40%. And it’s important to note that our book value decline is overwhelmingly due to rising rates rather than to weakening credit fundamentals. In fact, our loan portfolio is marked $732 million below par or $7.19 per share.

Now to be fair, our securitized debt is also marked below par by $368 million or $3.62 per share. But netting the 2 and assuming that our loans pay off at par and that we pay off our securitized debt at par, we have a potential upside in our economic book value of $3.57 per share. Page 8 of our earnings deck lays out this case, together with the strong credit fundamentals that support the loan portfolio. So looking ahead to 2023, this year has been anything but boring thus far. Rates rallied through the month of January as bond market participants became more and more confident that inflation trends were improving and expectations of further Fed tightening diminished. Agency mortgages looked attractive, particularly on a historical basis at the end of January.

The Fed announcement and press conference on February 1, provided further fuel to this dog rally. Then queue up the January employment report which came out in early February, followed by hot CPI and retail sales numbers and the bond rally suddenly became a bond route and we’re back near November highs on treasury yields. And once again, we learned that mortgages to look cheap but that doesn’t mean they can’t get cheaper. Credit markets have been considerably more constructive thus far this year with securitization spreads at least on AAA over 100 basis points tighter than they were in November. After printing just one securitization of $235 million of loans in the fourth quarter, we’ve already executed 3 securitizations in 2023 and a total of over $650 million of loans.

Not only were these spreads tighter for these deals but they were priced before the recent sell-off in rates. It seems clear to us that the Fed is neither certain about the magnitude of further rate increases nor clear on how long they will need to hold rates at restricted levels in order to break inflation. But it is pretty clear to us that the game is not over. We can debate whether or not we’re in the middle innings but we’re definitely not in the ninth inning. Our rate strategy remains in place as it has been since the second quarter of last year. We’ll continue to prioritize liquidity. We’ll continue to securitize loans and we’ll adjust market pricing and yields on our asset purchases to conform to market rates and funding costs. Finally, I’d like to talk a little bit about housing and residential mortgage credit.

Clearly, the selloff in rates and widening in mortgage spreads has had a profound impact on mortgage rates and housing activity has slowed dramatically. We’re beginning to see some modest home price declines at least month-over-month in some parts of the country. After the dramatic home price appreciation over the last 2 years, this should not be a surprise to anyone. However, as we again show on Page 8, our loan portfolio has considerable embedded HPA which combined with amortization, has lowered the current LTVs in most cases, to the mid-50s. In addition, delinquency trends have continued to improve across our portfolio. I’d like to turn the call over now to Gudmundur to talk about our portfolio activity and Lima One.

Gudmundur Kristjansson: Thanks, Craig. First, let’s turn to asset acquisitions. The combination of higher rates and our unique ability to source business purpose loans and non-QM assets allowed us to add high-quality credit investments that coupons you’ve not seen in a long time and perhaps never in the fourth quarter, with the average coupon purchased loans of about 9.5%. To put that into perspective, the average coupon on loans added was over 140 basis points higher compared to Q3 2022 and about 440 basis points higher than Q4 2021. Importantly, the credit quality of our acquisitions remains excellent with average LTV of 65% and average FICO above 740. We acquired $481 million of loans in the quarter and continue to find the best opportunities in business purpose loans originated by Lima One, where we were sourcing these assets substantially below the cost of purchase from third parties and can efficiently control the credit process.

These accounted for about 80% of our loan acquisitions in the fourth quarter with the remainder being selective acquisitions of non-QM loans. 2022 was the first full year of Limon operating under MSA’s ownership and the year when Lima emerged as a leading nationwide BPL originator with strong origination volume, excellent credit performance and prudent underwriting. Lima originated a record $2.3 billion in 2022, a 42% increase over 2021 and showed its importance to MSA’s balance sheet as Lima One originated loans accounted for about 2/3 of MSA loan acquisitions in 2022. The progress made in 2022 was due to clear strategic planning and great human resources. The collaboration between a talented and creative team at MFA and Lima have yielded tremendous benefits and the teams have worked tirelessly to execute our strategic vision in the BPL space.

I believe we’re just getting started and the market volatility over the last 12 months and going forward has and will continue to create opportunities for Lima to grow market share in the BPL space. Lima One has many strengths. Key among them is our strong focus on credit quality and risk management which combined with a disciplined underwriting and in-house servicing and construction management teams has led to very low delinquency levels on our Lima One BPL portfolio which has under 2% of 60-plus day delinquency as of December 31. In addition, Lima’s origination does not have excessive geographic or borrower concentrations. No state makes up more than 15% of our Lima One business purpose loans and no borrower exposure is more than 2% of our Lima One BPL portfolio.

Another important strength is Lima’s broad product offerings of both short-term and long-term financing solutions to experience real estate investors which allows us to maintain strong origination volumes through various economic and interest rate cycles. One area where the benefits of our collaboration has been very visible has been the securitizations of our business purpose loans. MFA has securitized over $1.4 billion of Lima One originated loans since our acquisition in the middle of 2021. We have securitized both short and long-term business purpose loans and created a differentiated platform where origination, servicing, asset management and risk retention are all under one roof. This control over the credit process and alignment of interest has resonated well with bond investors and helped us in closing our second transitional loan securitization this February which was the first marketed transition alone securitization in over 6 months.

These securitizations are nonrated and this market has effectively been closed in the second half of 2022 spreads blew out. Great credit to our team to get this market reopened and execute swiftly as rates and spreads declined in the beginning of 2023. We securitized about $150 million of transitional loans and now have over $400 million of these types of revolving securitization outstanding. Throughout 2022, we were focused on the impact of higher rates, tighter monetary policy and potentially softer economic conditions on our portfolio. To address those risks, we tightened underwriting standards, increased risk-based pricing adjustments and loan coupons in general throughout last year. As a result, we saw loan demand softening towards the end of last year with Lima’s Q4 origination volume down about 1/3 to $406 million.

We expect Q1 origination volumes to remain soft but are bullish on BPL origination volume for the remainder of the year and expect origination volumes to trend higher throughout 2023 as market volatility and higher financing costs allow Lima One to grow market share. We continue to be focused on liquidity and availability of financing to support our BPL origination and to that end, we expanded our RPL warehouse financing capacity of $100 million in the fourth quarter and by another $200 million so far in 2023. I will now turn the call over to Bryan Wulfsohn, who will discuss MSA securitization activity and portfolio credit performance in more detail.

Bryan Wulfsohn: Thanks, Gudmundur. 2022 proved to be a challenging year in the market for securitization issuance. MFA successfully navigated those conditions, issuing $2.3 billion of nonrecourse securitized debt through 9 securitizations across our different loan types. We were very active in issuing over the first 3 quarters of the year and that aggressiveness allowed us to be patient in the first quarter, issuing only one additional securitization while the spread to treasuries on AAA bonds moved back to the wise for the year of around 275 basis points. For reference, AAA spreads on non-QM and SFR started 2022 in the low 100 and moved higher throughout the year with only a short respite in the summer before pushing wider again.

The patients exhibited in the fourth quarter paid off early in 2023 as spreads on AAAs tightened in over 100 basis points and we have already issued another 3 securitizations totaling over $0.5 billion in bonds sold. We will continue to be a regular issuer in the market as we believe non-mark-to-market securitization financing provides significant benefits to our portfolio. Moving to our credit performance. 2022 marked a positive year of credit performance for the portfolio. Delinquencies on our purchase performing portfolio improved to 3% from 4 a year prior. The percentage of loans 60-plus days delinquent in December remained stable for the non-QM and SFR portfolios between 2% and 3%. The transitional loan portfolio improved further to 5%.

And the RPL portfolio exhibited 17% 60-plus with over 40% of those delinquent borrowers making payments. In the portfolio of loans purchased as NPLs, we had 41% of the remaining loans and 60-plus days delinquent. However, 31% of those borrowers are making payments. We once again had a successful quarter, liquidating properties from the REO portfolio. Over the quarter, we sold 83 properties or $29 million, resulting in $7.4 million in gains. Over the full year, we sold 416 properties for $134 million, resulting in $29 million in gains. We remain focused on our remaining nonperforming loans as momentum has shifted in home prices. Our asset management team is working to make sure our time line to resolution remain as short as possible as protracted time lines can be costly.

As a mitigant to extended time lines, our portfolio maintained a low LTV aided by the significant HPA experience over the past 2 years which helps limit potential losses. Overall, we believe the credit in our portfolio is well positioned for the current uncertain economic environment. And with that, we’ll turn the call over to the operator for questions.

Q&A Session

Operator: Our first question will come from JMP Securities and the line of Steve Delaney.

Steve Delaney: Congratulations on a strong close to 2022. Again, we look at the if you look at the $0.48 distributable EPS in the quarter, obviously, a big improvement from third quarter of $0.28. If we — I’m trying to look at it and put it in more of a — not just quarter-to-quarter but look at it as a distributable return on your economic book value and that puts us annualizing the 48 around a 12% to 12.5% rate. As you know your business better than anybody. Do you see that as a reasonably sustainable level? Does it reflect the kind of ROEs that you’re seeing in your current securitizations the deals that Gudmunder talked about in the first quarter of ’23. Are they being executed with returns that are consistent with what you put up in terms of an economic distributable return on economic book value in the fourth quarter?

Craig Knutson: Sure. So I think the $0.48 was influenced by a couple of things that I’ll let Steve address. And then maybe Gudmunder or Bryan can talk about sort of the static ROEs on the securitizations that the most recent securitizations that we’ve done. Is that — would that be helpful?

Stephan Yarad: Thanks, Steve. This is Stephen Yarad. So the $0.48 that we put up in the fourth quarter, it did have the benefit of some large items that occurred in the fourth quarter that won’t be necessarily recurring in future periods. On the interest income line, there was an MSR note redemption that did add $7.8 million to the net interest income for the fourth quarter. And we have had .

Steve Delaney: Was that 7.8%?

Stephan Yarad: Yes. We have had these types of redemptions in the past but that portfolio is a lot smaller now than it was a year or 2 ago. We also had a couple of large payoffs of delinquent loans that added about another $2.5 million to net interest income in the first — for the fourth quarter. On the REO side, we have REO gains consistently as Bryan mentioned but we did have a particularly large one in the fourth quarter that added about $2.9 million on the liquidation of that REO property. And that’s — as I said, we have REO liquidations routinely but that was a particularly large one and you wouldn’t necessarily expect a single property to have that sort of level of gain in any individual quarter. And finally and we talked about this a little bit in the press release, our compensation benefit number in our G&A was about $4 million lower this quarter than our regular run rate and that was due to the finalization of some year-end bonus accrual at both MFA and at Lima One.

And also, as Gudmundur alluded to, our origination volume at Lima was a little lower than the previous quarter and that had an impact on commission expenses that the sales reps get paid at Lima. So a little lower on that side as well.

Steve Delaney: are very helpful for us to try to adjust to something of a more normal run rate type of number. So thank you for that detail.

Gudmundur Kristjansson: And Steve, this is just to kind of start talking a little bit about our returns on investments, so in general, our approach, obviously, as we’re acquiring loans and adding new assets is to do it at levels where we can execute securitization and call it, double-digit returns, low to mid-teens, so to speak. And so that factors in the time it takes to aggregate loans and have them on a warehouse and had some things of that nature. And just for simple math, I mean, if you think about it, as we said in the press release, the loans originating at Lima One are coming in around 10% coupon or a little over 10% in the pipeline currently. So just the equity piece of that earns about 10%. So as we do the securitization with leverage, that gets us into that kind of mid-teens range.

And so what we are targeting and seeing is that on the transitional loans, whether it’s warehouse or execution or securitization, the returns on equity are about kind of mid- to high-teens returns. And then on the kind of the single-family rental and the non-QM in general, it’s probably kind of low to mid-teens ROE execution in terms of whether it’s on warehouse or securitization execution.

Operator: Then next from Credit Suisse, Douglas Harter.

Douglas Harter: Gudmundur, hopefully, hoping you could give me a little more clarity on one of the comments that you made about the cost to originate at Lima One versus the cost to acquire kind of in the third party, hoping you could put some details around that comment?

Gudmundur Kristjansson: Yes. Thanks for your question. I mean, I think simplistically, if you are acquiring loans for third parties, you’re paying premiums for those loans, whether those are longer-term resto loans or RPL loans. So your returns or your yield is going to be lower than the coupon that you’re adding on your balance sheet. And that can vary depending on market conditions. But that order of magnitude can be as high as 200 basis points lower than where you can create it yourself. And then — but running Lima is not 3, we be working there and things of that nature but they collect the origination fees and other fees as it relates to the origination activities. And the goal of the way we run the business is to largely have those fees and accelerate and origination fees kind of offset the cost of running Lima to try to create the loans for us as close to cost as possible which then is a significant boost in terms of the returns that we have by hoping in creating these loans on balance sheet.

Douglas Harter: And just to be clear, I guess relative to that goal kind of given where volumes are today. And then, I guess, what are your expectations for volumes…

Gudmundur Kristjansson: So you’re cutting up a little bit in the beginning, could you repeat the question?

Douglas Harter: Sure. Just where are you today on current volumes on that goal of kind of having the origination fees kind of cover the costs? And then what would the expectations be for volumes this year?

Gudmundur Kristjansson: Yes. I think — so in 2022, kind of early midyear, we were on track to have that kind of offset each other in the long run as volumes are increasing and we’re gaining efficiency. As we move into kind of Q4 and Q1 and as we alluded to, volumes came down a bit, right? And so as that happens, we’re probably running a bit in excess in terms of cost versus the income that’s coming in from the origination fees. But we think that as we head into 2023, that will kind of even itself out because we’re already seeing our pipeline increasing and expect volumes to pick up throughout 2023. And one of the reasons why we’re particularly bullish on that product is not necessarily the fact that we think that market is going to initially expand dramatically from a borrower demand.

But we see Lima continued to gain market share as the volatility in 2022 and the increases in financing costs in 2022 and into 2023, puts a lot of pressure on weaker originators that had — or thinly capitalized or we’re highly dependent on cheap money and leverage to make the business work. And as that is happening, we have been able to take market share and attract the better borrowers and the higher quality borrowers. And therefore, you see, for example, the delinquency performance in our portfolio substantially stronger than in other players out there. And so I think those things will also benefit us tremendously in 2023.

Operator: Next from KBW, Bose George.

Bose George: Actually I just wanted to follow up on Steve’s question on returns. How do the returns look on your in-place portfolio? Just your current portfolio .

Gudmundur Kristjansson: I guess you could look at the asset allocation table that’s in the press release, right? And that will break out — I mean at the bottom will show yield on average interest-earning assets and average cost of funds and I referenced the $3.7 billion that had only increased by 10 basis points. But that will break it out basically by product type. And then we have the leverage number there as well.

Bose George: I guess that doesn’t capture is the accretion, right? I mean, because you also have the discount securities that will be kind of rolling back into your ROE, is that right? The sort of the $3-plus that you referred to in terms of the discount in your portfolio?

Craig Knutson: Well yes. They do but that’s really a book value thing, right? And yes, it will flow through GAAP earnings but for distributable earnings that we’re going to back out any of those unrealized gains and losses. So that’s really that $3 number is really a book value potential accretion because if we get back par on the loans and we pay all the securities, the securitized debt off at par, that’s the upside. Because even though the rates on those mortgages might be below market, people still have to pay them off at par, that may take longer to get far than we thought originally but they still get paid off at par. And obviously, any amortization that comes through comes through at $0.10 on the dollar as well.

Bose George: That makes sense. They’re just trying to think of the sort of the economic return that the portfolio generates. But yes. No, that’s fair. And then also, I don’t know if you said this but what’s the book value? Where does that stand quarter-to-date?

Craig Knutson: So I know what it was at the end of — we had the number at the end of January. It was up about 7% to 8% in the month of January but I’d have to expect, given what rates have done in February that we’ve given a lot of that back in February but we don’t have an up-to-date number on that but that was a good January number.

Operator: Then next from BTIG, Eric Hagen.

Eric Hagen: I think I’ve got a few of them. Looking at the non-QM portfolio and the fundamentals, maybe at like the loan level, what would you say is the bull case there? Like especially relative to a levered agency strategy? Like even what are the prepayment speeds on the non-QM portfolio that loans are being priced to? Is there any room for that to get pulled forward? Another one on non-QM is a lot of last year was characterized by sort of older non-QM loans getting securitized to look like aggregators were kind of squeezed there. But how does that compare to returns on freshly originated non-QM and securitized non-QM? And then one more in the nonperforming loan portfolio, what are the solutions to speed up the time line to resolution like you mentioned, like can you share how you’re also financing the NPL portfolio right now?

Bryan Wulfsohn: Yes, sure. In terms of like non-QM versus agency, I guess, over the past year where we’ve seen relating to speeds and the like, agency speeds have dropped probably a little bit more significantly than non-QM because the non-QM borrower still may have an opportunity to get a conforming loan if they’re — if they’re able to cobble together the documentation to qualify for that type of mortgage. So we’ve seen on our portfolio over the last quarter, the speeds dropped but it was still sort of 7% CPR, where you could see on the — all the out-of-the-money sort of agency book might have been closer to 4% on speed. So you still have that sort of the natural turnover rate is expected to be a bit higher. Moving to sort of like you’re talking about old returns versus new returns.

On the non-QM opportunities out there, spreads are close to sort of $350 to $400 depending on speed. Prices — given rate volatility, prices for non-QM loans and pools out for bid are somewhat close to par given that sort of the range of outcomes because there’s so much uncertainty around rates is pretty high. So that naturally has given the availability of spreads to stay at that high level. So there is still potential for those returns because as we’ve seen the spread on the loans is probably $350 to potentially $400 million on the new loans and then in securitization, right? Spreads are in — on AAAs around the 150s and on AAs and As and the lower 200s. There’s still a fair amount of excess spread there, newly originated loans to clip that mid sort of low to mid-teens ROE that Gudmundur mentioned a few moments ago.

And relating to our nonperforming book, I mean, we’re doing sort of everything we can to make sure that, that time line stays short. And that goes back to sort of our experience with these loans over the past 7 years. And we’ve built out sort of a really good network again, the servicers that we work with, we have in-house people that are dedicated to foreclosure and bankruptcy situations. We have asset managers that have been doing this for many years. And we sort of think we’re probably better than most at making sure that time lines don’t extend. And this portfolio, remember, we haven’t added loans to this portfolio in a while. So if you look at the geographic concentration, right, of the portfolio shifted more towards the judicial states where there’s been just — the in general are longer time lines.

But eventually, you reach the end of those time lines. So we’re getting closer. And you can still see we’ve had a lot of activity of moving loans into REO where a lot of times we just end up getting full payoffs because of the equity position and the LTV situation on any given loan.

Operator: Then there are no other questioners in the queue at this time.

Craig Knutson: Okay. Thanks, Paul . So I want to thank everyone for their interest in MFA Financial and we look forward to our next update when we announce first quarter results in May.

Operator: Ladies and gentlemen, this conference will be available for replay after 12 noon Eastern Time today running through May 23 at midnight. That does conclude our conference for today. Thank you for your participation and for using the AT&T Event Conferencing Service. You may now disconnect.