Cherry Hill Mortgage Investment Corporation — 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018; filed March 18, 2019. This is an annual report, not a standalone fourth-quarter filing. Financial amounts below are U.S. dollars; amounts described in millions are rounded.
Business context
Cherry Hill is an externally managed residential mortgage REIT. It invests primarily in Agency and other residential mortgage-backed securities (RMBS) and mortgage servicing rights (MSRs), using leverage to finance much of its RMBS portfolio. Its stated objective is long-term risk-adjusted returns, primarily through distributions. The Company reported three segments: RMBS, servicing-related assets, and All Other.
Financial performance and position
| Metric | 2018 | 2017 |
|---|---|---|
| Interest income | $57.7 million | $42.0 million |
| Interest expense | $34.5 million | $19.9 million |
| Net interest income | $23.2 million | $22.2 million |
| Net servicing income | $40.2 million | $18.3 million |
| Total income, including realized and unrealized investment and derivative gains or losses | $49.0 million | $56.8 million |
| Net income | $37.8 million | $48.0 million |
| Net income applicable to common stockholders | $32.0 million | $45.5 million |
| Basic and diluted EPS | $2.18 | $3.98 |
| Core earnings attributable to common stockholders (non-GAAP) | $33.0 million; $2.25 per share | $25.5 million; $2.22 per share |
| Common dividends per share | $2.11 | $1.96 |
Interest income rose mainly as 2018 equity proceeds were invested in RMBS, while borrowing costs also increased with additional financing and higher repo rates. Servicing fee income more than doubled as the MSR portfolio expanded. Common-stockholder income and GAAP EPS fell despite higher core earnings; reported results included investment valuation movements and realized losses.
At year-end, total assets were $2.153 billion, total liabilities $1.789 billion, and stockholders’ equity $363.9 million. RMBS were $1.770 billion and servicing-related assets $294.9 million. Repurchase-agreement borrowings were $1.599 billion; notes payable were $157.5 million. Cash and cash equivalents were $31.8 million, with an additional $8.2 million of restricted cash.
Operating cash flow was $63.6 million; investing activities used $165.9 million; financing activities provided $85.8 million. Cash, cash equivalents and restricted cash ended the year at $40.0 million, versus $56.5 million a year earlier. Management said available liquidity was sufficient for short-term recourse liabilities and expected cash and operating flows to cover anticipated needs for the following 12 months.
At December 31, the RMBS portfolio’s weighted-average asset yield was 3.82%, and the reported period-end average net interest-rate spread was 1.72%. The portfolio’s year-end RMBS net interest spread was 1.31%, compared with 1.27% in 2017. Repo borrowings had a 2.54% weighted-average rate, 38-day weighted-average remaining maturity, and 4.2% weighted-average haircut.
Material changes versus the prior comparable period
- Interest income increased $15.7 million, while interest expense increased $14.6 million; net interest income rose by about $1.0 million.
- Net servicing income increased $21.9 million to $40.2 million. MSR carrying value grew to $294.9 million from $122.8 million, and underlying unpaid principal balance increased to $24.85 billion from $11.71 billion.
- Net income declined $10.2 million and common-stockholder income declined $13.5 million. Preferred dividends increased to $5.3 million from $1.8 million, and average common shares outstanding increased substantially following equity issuance.
- RMBS and MSR market-value effects were less favorable: MSRs recorded a $3.6 million unrealized loss, compared with a $9.2 million gain in 2017. Accumulated other comprehensive loss widened to $38.4 million, including a $35.5 million 2018 other comprehensive loss, principally from RMBS market-value declines as Treasury rates and credit spreads increased.
- Common and Series A preferred-stock offerings raised net proceeds during 2018; the Company reported investing offering proceeds primarily in RMBS. Repurchase borrowings decreased to $1.599 billion from $1.667 billion, while notes payable increased to $157.5 million from $39.0 million as MSR financing expanded.
Outlook, commentary, risks and unusual items
- Management said it did not anticipate executing its prime mortgage-loan strategy in 2019, citing market conditions and the availability of long-term financing. It expected a significant portion of RMBS paydowns to be deployed into MSRs and could sell RMBS to fund MSR purchases.
- Fourth-quarter 2018 net income was a loss of $38.8 million, and common-stockholder EPS was negative $2.42. Quarterly results included substantial unrealized derivative and MSR losses; the filing reports a $30.9 million unrealized derivative loss and a $21.9 million MSR valuation loss for the quarter.
- Key risks include short-term, uncommitted repo financing and margin calls; interest-rate, spread, prepayment and extension risk; dependence on third-party servicers; and subjective Level 3 MSR valuations. The Company’s sensitivity analysis indicates that a 100-basis-point parallel rate increase would reduce estimated RMBS value by $31.9 million, net of swaps, under the stated assumptions; it is a scenario, not a forecast.
- Freedom Mortgage gave notice that it would terminate its subservicing agreement without cause, with transfer expected in the second or third quarter of 2019. Freedom Mortgage serviced all Ginnie Mae MSRs. The related recapture agreement was also expected to end with the subservicing agreement.
- The Company is externally managed, and its manager has relationships with Freedom Mortgage. The management fee is based on stockholders’ equity, and the filing discusses potential conflicts of interest and termination costs.
- On February 11, 2019, after year-end, the Company issued 1.8 million Series B preferred shares, raising approximately $43.6 million net of underwriting discounts and commissions, before expenses. It intended to invest the proceeds in RMBS.
- No material legal or regulatory claims were reported as of December 31, 2018. The auditor gave an unqualified opinion on the financial statements and internal controls; management also concluded controls were effective.
Important facts for investors to verify
- Whether reported core earnings of $2.25 per common share are sustainable and how they reconcile to GAAP EPS of $2.18; core earnings is a non-GAAP measure and excludes specified realized and unrealized items.
- The assumptions and independent valuation support for MSRs, including prepayment, delinquency, servicing-cost and discount-rate inputs, and the drivers of the fourth-quarter valuation loss.
- The timing and terms for replacing Freedom Mortgage as subservicer, especially for Ginnie Mae loans, and any transition costs or operational effects.
- Repo counterparties’ renewal terms, collateral requirements and potential margin calls, given the short remaining maturities and uncommitted nature of the facilities.
- How the 2019 Series B proceeds and anticipated RMBS paydowns will be allocated, and the resulting effect on leverage, distributions and common-stockholder returns.
- Preferred-dividend obligations, common dividend coverage, and the effect of additional equity issuance and dilution on per-share results.