Business context and reporting period
Cherry Hill Mortgage Investment Corporation (CHMI) is an externally managed residential mortgage REIT focused on Excess mortgage servicing rights (Excess MSRs) and residential mortgage-backed securities (RMBS). This Form 10-K covers the fiscal year ended December 31, 2014; it also reports fourth-quarter results. CHMI began operations in October 2013, so full-year 2014 comparisons with 2013 are not like-for-like: 2013 included only 81 operating days.
Financial performance and condition
Unless otherwise noted, amounts below are in millions of dollars. Full-year 2014 interest income was $25.0, interest expense $4.3 and net interest income $20.7. Net income was $2.4, or $0.31 per diluted share, compared with $21.2, or $12.50 per share, in 2013. The prior-year result included a $15.6 unrealized gain on Excess MSRs; 2014 recorded a $3.6 unrealized loss on those assets and $6.6 in unrealized derivative losses. Realized derivative losses were $2.6. RMBS unrealized gains of $11.7 were recorded in other comprehensive income, not net income.
In fourth-quarter 2014, interest income was $6.6, interest expense $1.2 and net interest income $5.4. The quarter reported a net loss of $0.5, or $0.07 per share, including $2.4 of unrealized derivative losses and a $0.5 Excess MSR fair-value loss. The RMBS portfolio’s reported net interest spread was 1.67% at year-end, up from 1.43% a year earlier.
At December 31, 2014, total assets were $531.9, including $416.0 of RMBS, $91.3 of Excess MSRs and $12.4 of cash and cash equivalents; restricted cash was $6.9. Repurchase-agreement debt was $362.1, versus $261.3 a year earlier, and total stockholders’ equity was $160.3. RMBS debt-to-equity leverage was approximately 6.2:1, compared with 6.3:1. Repurchase borrowings had a 0.38% weighted-average rate, a 63-day weighted-average remaining maturity and a 5.4% average haircut.
Operating cash flow was $25.0; investing activities used $105.8 and financing activities provided $82.9. Common dividends were $2.03 per share for 2014, compared with $0.45 in 2013; the fourth-quarter dividend was $0.51 per share.
Material changes versus the prior period
- RMBS carrying value increased to $416.0 from $287.0, while Excess MSR carrying value declined to $91.3 from $110.3. The underlying loan UPB for Excess MSRs fell to $17.5 billion from $20.0 billion.
- Net income fell substantially year over year, but the comparison is distorted by the shorter 2013 operating period and its large Excess MSR fair-value gain.
- Repurchase debt rose by $100.8 million. The RMBS net interest spread widened to 1.67% from 1.43%.
- RMBS fair-value changes shifted from a $5.0 million unrealized loss in 2013 to an $11.7 million unrealized gain in 2014, reflecting, in part, an 86-basis-point decline in interest rates during 2014.
Outlook, risks and unusual items
Management said asset pricing had reduced available investment returns and that it was unlikely CHMI could maintain its 2014 dividend level in 2015. It planned to broaden investments to seek a more diversified and stable revenue profile, while cautioning that this strategy could lower dividends and requires capital; there is no assurance when or whether that capital will be raised. Prime mortgage loans were not expected to enter the portfolio before the second half of 2015, if at all.
In February 2015, CHMI’s taxable REIT subsidiary agreed to acquire Aurora Financial Group and its servicing business, subject to regulatory and agency approvals. Aurora serviced approximately $700 million of Fannie Mae and Freddie Mac RMBS at year-end 2014. The filing anticipated a second-quarter 2015 close but gave no assurance the transaction would close on that schedule or at all.
Key risks include short-term, uncommitted repo financing and margin calls; interest-rate, spread, prepayment and extension risk; and reliance on Freedom Mortgage, which services all Excess MSR pools disclosed at year-end. Excess MSRs are illiquid Level 3 assets whose valuations depend on management assumptions. Related-party and management conflicts, REIT qualification requirements, and the ability to maintain Investment Company Act exclusions also constrain the business. The company disclosed potential liability under agency acknowledgment agreements if a servicer fails to make required payments, although management considered material loss remote and recorded no liability. The filing also describes a HUD Inspector General inquiry involving Freedom Mortgage; Freedom Mortgage had reported no allegations or monetary demand as of the filing date, but said a significant initial monetary demand was reasonably likely.
Management stated that cash on hand and operating cash flows were expected to cover anticipated liquidity needs for the next twelve months, including potential margin calls and operating expenses. The independent auditor issued an unqualified opinion on the financial statements; it was not engaged to audit internal control. Management concluded disclosure controls and internal control over financial reporting were effective at year-end.
Important facts for investors to verify
- Whether 2015 dividends were reduced as management anticipated, and how cash available for distribution compared with taxable income and GAAP earnings.
- The assumptions and independent valuation evidence supporting the $91.3 million Level 3 Excess MSR valuation, including prepayment, delinquency and discount-rate inputs.
- Freedom Mortgage’s servicing performance, recapture results, financial condition and any developments in the HUD OIG inquiry; assess the concentration of all disclosed Excess MSRs with that servicer.
- Repo renewal terms, counterparty concentration, collateral haircuts and liquidity available to meet margin calls as short-term borrowings mature.
- The status, approvals, financing and final terms of the Aurora acquisition, and whether it delivered the anticipated strategic benefits.