Cherry Hill Mortgage Investment Corporation - Q2 2024

Transcript

Operator (participant)

Good day, and welcome to the Cherry Hill Mortgage Investment Corporation's Second Quarter 2024 Conference Call. At this time, all participants are in listen-only mode. After the speaker's presentation, there'll be a question-and-answer session. Instructions will be given at that time. As a reminder, this call may be recorded. I would like to turn the call over to Garrett Edson with Investor Relations. Please go ahead.

Garrett Edson (Head of Investor Relations)

We'd like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation's Second Quarter 2024 Conference Call. In addition to this call, we have issued a press release that was distributed earlier this afternoon and posted that press release and a second quarter 2024 investor presentation 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 our ability to complete the planned internalization of our management, 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 (President and CEO)

Thanks, Garrett, and welcome to our second quarter 2024 earnings call. The second quarter was very much a tale of two halves. As we entered April, markets continued to react to the Fed, which maintained hawkish language with respect to rates as inflation hovered slightly below 3%. As the quarter progressed, the Fed became considerably more dovish, given the uptick in unemployment and softer economic data. The weaker data has ultimately led to expectations that the Fed will ease monetary policy starting in September. We expect volatility will persist in the near term, in part due to current geopolitical unrest, the upcoming U.S. presidential election, and central banks globally having begun to cut interest rates. This was evident in the past week's market activity across equities and bonds.

Wider spreads ultimately impacted our portfolio's performance in the quarter, albeit mitigated by our hedging strategy of utilizing TBAs in addition to interest rate derivatives. Looking forward, we are optimistic about what we and the market are seeing in terms of the economy's resilience thus far, yet mindful of the economy cooling off. With a high degree of likelihood around rate cuts, the yield curve is steepening, and we are continuing to align our portfolio to take advantage as the curve steepens. We continued to watch economic indicators in the Fed closely and believe our overall strategy of pairing MSRs with agency RMBS works well in the current environment

Post-quarter end, we announced that our special committee, which is comprised solely of independent and disinterested directors, determined and recommended to the board to internalize management of Cherry Hill and that Cherry Hill's officers take all steps necessary to begin operating Cherry Hill as a fully integrated, internally managed mortgage REIT. Once completed, internalization should reduce our expenses, enhance earnings, and better align management in the investment community. Subsequent to our announcement, we have been working to complete the internalization so that we can transition to self-management. As we noted on our last earnings call, we will not discuss any information or developments relating to the special committee or its process until the evaluation of strategic alternatives has been completed or the special committee determines further disclosure is appropriate or legally required. Their focus remains on doing what is in the best interest of the company and its shareholders.

For the second quarter, we generated GAAP net loss applicable to common stockholders of $0.06 per diluted share, and we generated earnings available for distribution, or EAD, a non-GAAP financial measure of $2.3 million or $0.08 per share. EAD for the quarter was impacted by $0.06 per share of expenses related to the special committee's efforts. A reminder that EAD is just one factor the board of directors considers in setting our dividend policy, as we've previously noted, and it is not the primary factor. Also considered is the existing market environment, portfolio return potential, our level of taxable income, including hedge gain impacts, and the degree of certainty regarding forward investment return economics. Thus, while EAD may continue to remain under our dividend level in the near term, we believe other factors are important when considering whether we can sustainably cover our dividend.

During the quarter, we strategically sold over $1 billion of UPB in low loan balance MSRs. We believe the sale will improve our portfolio's efficiency and reduce servicing costs for our remaining MSR portfolio. Book value per common share finished the quarter at $4.15, compared to $4.49 on March 31st. The reduction was driven in part by special committee expenses and higher dividend payments on our Class B preferred. We continue to opportunistically repurchase Class B preferred shares to further stabilize our equity profile. On a NAV basis, which includes preferred stock in the calculation, NAV was off approximately $12.4 million, or 5% relative to March 31st. This is inclusive of repurchasing approximately $2.2 million of Class B preferred shares and approximately $1.7 million of special committee-related expenses.

Financial leverage at the end of the quarter rose to 4.9x as we continued to stay prudently levered, given the volatility in the market. We ended the quarter with $52 million of unrestricted cash on the balance sheet, maintaining a solid liquidity profile. As we have previously discussed, while our financial leverage has stayed relatively low, our capital structure leverage, consisting of our mix of common to preferred equity, amplifies how changes in our NAV or total equity impacts our common book value per share. Thus, we have been repurchasing Series B preferred shares to stabilize our equity profile, particularly since the Series B preferred shares are now floating rate.

As of August 7th, we have repurchased approximately 9.4 million of Series B preferred shares, and we expect to continue repurchasing preferred shares moving ahead, while remaining mindful of our balance sheet strength and our investment portfolio. Looking ahead, we are closely monitoring the macro environment as we look to position our portfolio appropriately should the Fed begin to lower rates. In the near term, we will expect to deploy capital into Agency RMBS, which still presents a strong risk-adjusted return profile, and reduce the portion of preferred equity in our capital structure to provide greater stability of our equity profile for the ultimate benefit of common shareholders, while maintaining our strong liquidity and leverage.

With that, I'll turn the call over to Julian, who will cover more details regarding our investment portfolio and its performance over the second quarter.

Julian Evans (Chief Investment Officer)

Thank you, Jay. As Jay noted, the Fed started the quarter concerned that inflation was too high. As the quarter progressed, inflation reduced to levels that were in line with their expectations. The Fed voice turned dovish as economic data did not meet market expectations. Given recent market data and Fed rhetoric, we expect the Fed to reduce rates at the September meeting. The magnitude of the eases is yet to be determined. While wider spreads, special committee expenses, and preferred share repurchases impacted our book value in the second quarter, with more certainty potentially coming into the market surrounding rates, we may finally begin to see the macro environment normalize and potentially the end of the inverted yield curve. We will continue to monitor the Fed closely in case there is any shift from their current sentiment.

At quarter end, our MSR portfolio had a UPB of $18 billion and a market value of approximately $234 million. As Jay mentioned, we sold over $1 billion of UPB during the quarter to make our MSR portfolio more efficient and reduce servicing costs. The MSR and related net assets represented approximately 42% of our equity capital and approximately 26% of our investable assets, excluding cash at quarter end. Meanwhile, our RMBS portfolio accounted for approximately 40% of our equity capital. As a percentage of investable assets, the RMBS portfolio represented approximately 74%, excluding cash at quarter end. Prepayment speeds for our MSR and RMBS portfolios continued to remain relatively steady compared to the prior quarter, given the elevated mortgage rate environment.

Our MSR portfolio's net CPR averaged approximately 5.5% for the second quarter, compared to 3.9% net CPR in the previous quarter. The portfolio's recapture rate remained low at approximately 0.3%, as the incentive to refinance continues to be minimal. Moving forward, we continue to expect a low recapture rate and a stable net CPR for at least the near term, given our portfolio's loan rate. The RMBS portfolio's prepayment speeds remain low, driven by a combination of new asset purchases, as well as the current higher mortgage rate environment, which continues to compress CPRs for the existing portfolio. At quarter end, most of the mortgage universe remained out of the money in terms of refinancing based on those levels. We would expect prepayments to remain at low levels based on quarter end levels.

Since the end of the quarter, interest rates have declined to levels that should cause refinancing activity to start to pick up. The expectation for the Fed to lower rates has increased. We could see prepayments rise as the Fed follows through with lowering rates. For the quarter, the RMBS portfolio's weighted average three-month CPR fell to approximately 4.6%, compared to approximately 5.2% in the first quarter. As of June 30th, the RMBS portfolio, inclusive of TBA, stood at approximately $674 million, up marginally compared to the previous quarter end. Quarter-over-quarter, we acquired additional higher coupon RMBS, and we continue to remain positioned to protect against additional spread widening. For the second quarter, our RMBS net interest spread was approximately 3.23%.

The reduction from the prior quarter was driven primarily by higher repo costs as we financed more securities and a reduction in our swap income, which offset increased RMBS income for purchases. As Jay mentioned, the portfolio's financial leverage stood at approximately 4.9x, and the 30-year securities position continued to represent 100% of the RMBS portfolio at quarter end. Moving forward, we will continue to proactively manage our portfolio, while continuing to shift our overall capital structure to add value for shareholders through improved performance and earnings.

I will now turn the call over to Mike for a second quarter financial discussion.

Michael Hutchby (CFO)

Thank you, Julian. GAAP net loss applicable to common stockholders for the second quarter was $1.9 million, or $0.06 per weighted average diluted share outstanding during the quarter. While comprehensive loss attributable to common stockholders, which includes the mark-to-market of our available for sale RMBS, was $5.5 million or $0.18 per weighted average diluted share. Our earnings available for distribution attributable to common stockholders were $2.3 million or $0.08 per share. EAD is inclusive of approximately $1.7 million or $0.06 per share of expenses related to the special committee's work. Our book value per common share as of June 30th was $4.15, compared to a book value of $4.49 as of March 31st.

We use a variety of derivative instruments to mitigate the effects of increases in interest rates on a portion of our future repurchased 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 approximately $954 million. You can see more details with respect to our hedging strategy in our 10-Q, as well as 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 $5.1 million for the quarter, which included the $1.7 million of special committee-related expenses.

On June 13th, our board of directors declared a dividend of $0.15 per common share for the second quarter of 2024, which was paid in cash on July 31st. We also declared a dividend of $0.5125 per share on our 8.2% Series A cumulative redeemable preferred stock, and a dividend of $0.6995 on our 8.25% Series B fixed-to-floating rate cumulative redeemable preferred stock, both of which were paid on July 15th. At this time, we will open up the call for questions. Operator?

Operator (participant)

Thank you. If you would like to ask a question, please press star one one. If your question has been answered and you'd like to remove yourself from the queue, please press star one one again. One moment for questions. Our first question comes from Mikhail Goberman with Citizens JMP. Your line is open.

Mikhail Goberman (Analyst)

Hey, good evening, guys. Hope everybody's doing well. If I could start with the, I don't know if you guys can answer this, given that it's related to the special committee, but the $0.06 of expenses this quarter, is that something that is going to be popping up until the committee completes its work?

Julian Evans (Chief Investment Officer)

Hey, Mikhail, it's Jay.

Mikhail Goberman (Analyst)

Hey, Jay.

Jay Lown (President and CEO)

I don't have a number for the third quarter, so I can't tell you what I think that number would be for the current quarter. But the committee is still in effect, and I would anticipate some expenses this quarter related to the committee's efforts.

Mikhail Goberman (Analyst)

Gotcha. Thanks. And, can you guys maybe flesh out your comments, as you're thinking about the interplay between agency MBS and MSRs going forward in a lower rate environment? How are you thinking about the trade-offs between the two portfolio stalwarts, especially in terms of lowering the MSR component? Thanks.

Julian Evans (Chief Investment Officer)

Hi, Mikhail, it's Julian.

Mikhail Goberman (Analyst)

Hey, Jay.

Julian Evans (Chief Investment Officer)

At the moment, we see RMBS as a good place to invest money. Right now, those yields are probably between 14% and, let's call it 17% return on equity. So we like that return. So I would say at the moment, additional cash flows will be probably going into RMBS.

Mikhail Goberman (Analyst)

In terms of MSR sales, that's something you guys are going to continue to opportunistically look into?

Julian Evans (Chief Investment Officer)

So, a good question. That sale is very strategic. You know, I think we looked at the portfolio, looked at the low balance loans, the drag that it was putting relative to the expense side of running that business. And, we've been engaged with the counterparty for a while that has an interest in that portfolio, and we're very happy with the execution on that portfolio. And, you know, look, you're always mark to market. You're available for sale. So to the extent that something occurs where we think there's an opportunity to take advantage of the strong market, there's a possibility. But there's nothing, you know, planned today around a sale in that portfolio that would be meaningful.

Mikhail Goberman (Analyst)

Got you. Thanks, guys. It wouldn't be an earnings call without a question about current book value, so.

Michael Hutchby (CFO)

I figured that was coming.

Mikhail Goberman (Analyst)

There it is.

Michael Hutchby (CFO)

There it is. So at the end of July, we see our book value basically flat to quarter end, and that is, of course, before any third quarter dividend accrual, as the board has not yet met to approve a dividend for the quarter.

Mikhail Goberman (Analyst)

Got you. Thanks, guys. Best of luck going forward with the internalization and everything else. Thanks.

Jay Lown (President and CEO)

Thanks, Jay.

Operator (participant)

Thank you. Our next question comes from Matthew P Howlett with B. Riley. Your line is open.

Matthew Howlett (Analyst)

Oh, hey, Jay. Hey, guys. Hey, thanks for taking my question, and hey, and congratulations on the enormous milestone of internalizing the company. Again, I know you're limited in what you can say, but just, Jay, you know, high level, what, you know, this is a huge turn for the company. Can you just give us some, you know, you know, what, what you can tell us about how the company will operate now internally versus what it's done historically, and just, just some high level, you know, words around that, if you could?

Jay Lown (President and CEO)

Yeah. Hey, Matt. So I, I'll apologize upfront for saying there's not much I can say. You know, the goal has been to. We've been looking at this for a long time, you know, relative to being externally managed, understanding the efficiencies around running the company internally. And I think the special committee has evaluated that versus other options and, you know, as announced in the press release, elected to move forward to terminate, you know, being externally managed and perhaps for us to run the company independently and internally.

But, broadly speaking, you know, it's the same group of people, it's the same structure, and we're looking forward to being able to do a better job of being able to respond to changes in the market, the ability to potentially make some changes in the assets that we invest in, et cetera. And we think it'll give us, you know, a lot more flexibility with respect to how we run the business. So we're, you know, we're pretty excited about the development.

Matthew Howlett (Analyst)

Yeah, look, I think, I think the independent board made the right decision. Last week, we can all do the math, efficiencies, and we just look forward to, I mean, are you expecting this to, in, you know, next quarter, by the fourth quarter, be able to come out and just unveil this and tell everyone about, will this be done by then? I mean, just can you give us a sense when it'll be completed?

Jay Lown (President and CEO)

Yeah, so I tried to be pretty clear on the script that, you know, the special committee is comprised of the independent directors, and, you know, that does not include me. So, you know, broadly speaking, I don't have a feel for timing on that just today. And, I expect that, you know, should they feel compelled to put something out that's more definitive than what was previously announced, I'm sure they would do that.

Matthew Howlett (Analyst)

Great. Okay. Well, we look forward to that, and I think it is an exciting time for everybody. And, congrats on the outcome. I guess just moving towards the portfolio, I mean, you're staying, you know, up in coupon, it looks like, you know, the payups. Just give us a sense on, one, what are the premiums that you're paying? I mean, these specified pools, I mean, what are you looking at? And then two, let's just talk about the Fed. I mean, you know, I think you guys said you don't really know whether it's 20, you think it's 25 or it's 50 in September, but let's just talk about next year. I mean, is it 150, 200?

I mean, how are things gonna change on the portfolio from asset selection, from hedging, if, you know, if the Fed is gonna really start lowering aggressively here? Or we just don't know, and you're just gonna have to wait and see. I just think it's such an interesting time. You guys have been very defensive, and you've really managed the volatility very well, better than probably any mortgage REIT out there. But now it looks like we're in the cusp of this change in cycles. So first, talk about the asset selection, and then two, just tell me how you're gonna position if the Fed does start cutting aggressively.

Julian Evans (Chief Investment Officer)

Matt, Julian. I'll start with kind of like the positioning in terms of, like, security selection. You know, in terms of, like, specified pools, we've been purchasing specified pools probably for, like, the last, you know, throughout the last year, kind of trying to improve the overall quality of our portfolio, buying loan balance, type of collateral. Pretty much been sticking somewhere in between 200 and 250K max type pools. You can obviously see that in the collateral story slide that we have in the portfolio. And if you go back a couple presentation, we'll kind of show you kind of the migration. In the beginning, we probably haven't paid a lot for pools. We've been really trying to stick to something that's probably been around half a point.

We've probably migrated to a few things that have gotten up to maybe a full point that we're having to purchase. I think as rates have kind of lowered here in the last couple weeks, specified stories have obviously gotten more expensive, and so we're trying to have a cautious approach about what we're adding to the portfolio, and does it meet kind of an investment returns? I think as the Fed kind of progresses in terms of what they want to do over the next year, the portfolio will obviously change. I think as a group, our initial expectation was that the Fed, let's say, within this year to the end of 2025, would probably end up doing about six eases, so maybe two this year and four throughout 2025.

Now, that's making a basic assumption that we're not in a recession and the Fed is basically trying to do some normalization type of eases. If we are entering into a period of possibly a recession, I think the Fed would obviously be a lot more aggressive in terms of the amount of cuts that they want to do. So you could easily end up seeing 200 basis points or more of cuts if the Fed had to get very aggressive to kind of bring growth back into the environment. Look, I think anytime you're managing a portfolio like this, you're trying to look and manage the portfolio within 25 basis point increments. Once it steps out of 25 basis point increments, you have to think about readjusting your hedges and always think about the different types of positioning.

I think some of the things we've been seeing from the Fed, obviously, is the potential, if we are entering into a slowdown in terms of labor versus rate, and rates want to move very aggressively forward. At one point, we were probably almost down 70 basis points within the quarter. Obviously, we have to think about adjustments on the portfolio. I think July, we were down maybe about 20, 25, and then we-- obviously, the first couple of days of August, we pushed almost another 50 down, and then have subsequently reversed some of that. So we're trying to be very selective and cautious about where we think Fed policy will be going. But not only is there volatility within that, I think we also have to think about the election and the overall economy in terms of what it's doing. Let's see if Jay has anything.

Jay Lown (President and CEO)

Yeah, the only thing I'll also add, Matt, is, look, we're not opposed to investing in MSRs. I think we're not the only entity out there over the last three or four plus months that have taken advantage of what we would call a very strong market for that asset class. And I think, you know, Two Harbors also sold some assets as well. So from our perspective, it's a risk-return profile discussion around where we think we're supposed to deploy the capital. And, you know, as Julian's mentioned a couple of times today, sitting here today, we think that's RMBS. That could change. You know, if the MSR market sort of stabilizes and gets a little cheaper, then sure, we're not opposed to owning current coupon MSRs at the right levels.

We just are supposed to take advantage of opportunities that benefit shareholders, and we think we did that in the second quarter.

Matthew Howlett (Analyst)

Okay, that's interesting, because your existing MSR book has got a 3.5% WAC. I mean, those, I think, we'll agree that mortgage rates, it would take a lot, a lot to get, you know, those people in the money to refinance. But what you're saying is, you would, you'd be open to current coupon MSRs at the right price. I mean, that's interesting. What is it because you feel good about recapture? Is it because you feel good about just asset selection looking? Or do you just feel like prices could fall off a cliff at some point and you'd be interested at that time?

Jay Lown (President and CEO)

No, it's more at the right level, we think current coupon MSRs do a good job of hedging the MBS.

Matthew Howlett (Analyst)

Right.

Jay Lown (President and CEO)

So, you know, with the MSR current note rate at 3.5%, it's not, you know, significantly hedging the RMBS portfolio. It's performing like a rock star, but broadly speaking, it's not the best hedge for the MBS, given, you know, the differential in the current coupons. But, you know, at the right levels, we've always been prepared to buy MSRs.

Matthew Howlett (Analyst)

Right. No, you guys, it's been an excellent strategy, and, and, I don't think anyone—I mean, it's a nice trade you did. It sounds like it's going to improve your costs, and, and it's an excellent trade, but it's great to hear that you're still committed to that strategy. Last question. I think, you know, you know, I, it wouldn't be an earnings call if I didn't ask about leverage, and, and you guys have a lot of dry powder, but, you know, what would it take, I mean, for you guys to really just say, This is, you know, this is it. Curve's going to steepen, spreads are going to tighten, and we're going to take our leverage up, because at some point, repo's going to be that 2.6%, you know, rate going looking out. I mean, just talk about the excess company capital in the company today, and, you know, when would you really—what would you need to see to get more aggressive on leverage?

Jay Lown (President and CEO)

So we are definitely on the low end of the leverage side relative to, I would guess, our peers that, you know, share the same strategies. And that comes from really, the less leverage on the MBS side.

Matthew Howlett (Analyst)

Yeah.

Jay Lown (President and CEO)

From the MSR side, you know, we're levered pretty similarly to our peers, and so the question really becomes: When do we get comfortable enough with MBS relative to spread risk and just the market related around, you know, what the Fed's doing and who the true buyers are for the asset classes? And it's an ongoing conversation and debate about where we think spreads could go from here. But I do expect that as we get closer to an easing cycle on the Fed side, we would be more comfortable taking additional risk on that side of the house.

Matthew Howlett (Analyst)

Yeah, that's clearly the true upside that we're all looking into all potential. But I think that obviously congrats with the internalization and the, you know, the new chapter in Cherry Hill. We really look forward to it and really look forward to the next year. So, congrats to the team and everybody. Thanks. Thanks, Jay.

Jay Lown (President and CEO)

Sure. Thanks, Matt.

Operator (participant)

Thank you. As a reminder, if you'd like to ask a question, please press star one, one. There are no further questions at this time. I'd like to turn the call back over to Jay Lown for closing remarks.

Jay Lown (President and CEO)

Thanks, operator. Thank you, everyone, for joining us on our second quarter 2024 earnings call, and we look forward to updating you on our third quarter earnings call in November.

Operator (participant)

Thank you for your participation. This does conclude the program, and you may now disconnect. Everyone, have a great day.