Cherry Hill Mortgage Investment Corporation — 2013 Form 10-K
Business context and reporting period
Fiscal year ended December 31, 2013. Cherry Hill began operating on October 9, 2013, after its IPO and concurrent private placement. It is an externally managed residential mortgage REIT focused on Excess mortgage servicing rights (Excess MSRs) and Agency RMBS. Results for 2013 are not meaningfully comparable with 2012, when the company was pre-operational.
Financial performance, position and liquidity
- 2013 income: Interest income was $5.475 million and interest expense $0.867 million, producing net interest income of $4.608 million. Total income was $22.534 million; net income was $21.202 million and net income applicable to common stockholders was $21.095 million.
- Earnings quality: Results included a $15.647 million unrealized fair-value gain on Excess MSRs and a $2.747 million unrealized gain on derivatives. Agency RMBS sales produced a net realized loss of $0.527 million. Reported EPS was $12.50, but the company said a normalized calculation using 7.5 million shares gives $2.81 because shares were outstanding for only part of the year.
- Cash flow: Operating cash flow was negative $6.080 million and investing cash flow negative $387.414 million; financing cash flow was positive $403.868 million. Year-end cash and cash equivalents were $10.375 million, plus $3.744 million of restricted cash.
- Balance sheet at year-end: Total assets were $427.398 million, total liabilities $266.276 million and total stockholders’ equity $161.122 million. Agency RMBS were carried at $286.979 million and Excess MSRs at $110.306 million.
- Debt and liquidity: Repurchase borrowings totaled $261.302 million, secured by Agency RMBS; the weighted-average repo rate was 0.39%, haircut 5.5%, and remaining term 29 days. Agency RMBS debt-to-equity was approximately 6.3:1. Management stated liquidity was sufficient for short-term recourse liabilities and anticipated needs over the next 12 months, including potential margin calls.
- Margins: The reported Agency RMBS weighted-average asset yield was 2.98%, funding cost 1.55%, and net interest spread 1.43% at year-end.
- Dividend: The company declared $0.45 per share for the 81 days following the IPO, payable in January 2014. A $0.50-per-share first-quarter 2014 dividend was declared after year-end.
Material changes versus prior period
The company moved from a pre-operational entity with $1,000 of assets at December 31, 2012, to a funded mortgage investment company following its October 2013 offering. It raised approximately $148.1 million net, invested in Excess MSRs and Agency RMBS, and established repo financing and derivative positions. The 2012 loss of $25,000 reflects the short inception period and is not a useful operating comparison.
Outlook, commentary, risks and unusual items
- Management’s strategy was to allocate a majority of equity capital to Excess MSRs, finance Agency RMBS with leverage, and consider prime jumbo loans over time. The filing said prime jumbo assets were not expected to be significant before at least 2015, if at all. No numerical earnings or dividend guidance was provided.
- Management expected lower recapture activity as rates rose, while anticipating overall prepayment rates to remain roughly constant. Future results remain sensitive to rates, prepayments, delinquencies, credit spreads, asset valuations and financing availability.
- Excess MSRs were concentrated in loans serviced by Freedom Mortgage, an affiliate of the Manager and the sole servicer for the company’s initial Excess MSR portfolio. Servicer termination could materially reduce or eliminate the value of those assets. The portfolio’s Excess MSR value depended on Level 3 estimates and assumptions.
- Repo financing is short-term and uncommitted, with margin-call, refinancing and counterparty risks. The filing also describes potential payment liability under Ginnie Mae acknowledgment agreements if the servicer defaults.
- Related-party dependence and conflicts are significant: Freedom Mortgage and the external Manager are controlled by the Chairman. The Manager receives a 1.5% annual fee based on stockholders’ equity, regardless of portfolio performance.
- Freedom Mortgage reported receiving a HUD OIG subpoena concerning FHA origination quality-control and training records and said it was cooperating; the filing reported no allegations or findings communicated at that time. Cherry Hill itself reported no legal proceedings as of year-end.
- The company intends REIT treatment and must meet distribution and qualification tests. Failure to qualify, or adverse tax treatment of Excess MSRs or other assets, could affect taxes and distributions. The independent auditor gave an unqualified opinion on the financial statements; it did not opine on internal control effectiveness, citing the newly public company transition period.
Important facts for investors to verify
- How much of reported earnings and book value reflects recurring cash income versus fair-value movements, particularly the Excess MSR valuation gain.
- The valuation assumptions and sensitivity of the Level 3 Excess MSRs, and the effect of servicer concentration, recapture performance and any servicing transfer.
- Repo renewal capacity, collateral haircuts, margin-call liquidity and the company’s actual leverage as the portfolio grows.
- The terms and oversight of transactions with Freedom Mortgage and the Manager, including fees, purchase pricing and conflicts of interest.
- Ongoing REIT qualification and any developments in the HUD OIG matter involving Freedom Mortgage.