Cherry Hill Mortgage Investment Corp quarterly report, Q3 FY2016

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Cherry Hill Mortgage Investment Corporation — Q3 2016 Form 10-Q

Reporting period: Three and nine months ended September 30, 2016. Cherry Hill is an externally managed residential mortgage REIT investing primarily in agency mortgage-backed securities (RMBS) and mortgage servicing-related assets. Amounts below are in millions unless stated otherwise.

Financial performance and position

  • Q3 results: Interest income was $7.16 versus $5.81 in Q3 2015; net interest income was $5.28 versus $4.17. Net servicing income rose to $1.72 from $0.10. Net income attributable to common stockholders was $5.44, or $0.72 per share, compared with a loss of $5.12, or $0.68 per share, a year earlier.
  • Nine-month results: Interest income was $19.48 versus $19.73, and net interest income was $14.06 versus $15.50. Net servicing income increased to $3.89 from $0.16. The company reported a common-stockholder loss of $1.34, or $0.18 per share, compared with income of $3.67, or $0.49 per share, in 2015.
  • Non-GAAP measure: Core earnings attributable to common stockholders were $4.05, or $0.54 per share, in Q3 and $12.07, or $1.60 per share, for nine months. Management cautions that core earnings exclude significant realized and unrealized items and are not a substitute for GAAP results.
  • Interest spread: Period-end average net interest rate spread was 2.02% in Q3, up from 1.77% in Q2 2016 and 1.08% in Q3 2015. RMBS net interest spread was 1.63%, versus 1.46% at year-end 2015. The company said tighter spreads affected yields during the quarter.
  • Fair-value and other items: Q3 included a $3.20 gain on derivative fair value, partly offset by a $1.85 MSR fair-value loss; nine-month derivative fair-value losses were $3.23 and servicing-related asset fair-value losses were $9.49. Nine-month comprehensive income attributable to common stockholders was $10.64, including $12.17 of other comprehensive income, primarily RMBS marks.
  • Cash flow: For the first nine months, operating activities provided $26.12, investing activities used $22.88, and financing activities used $1.26. Cash and cash equivalents were $12.59 at quarter-end; restricted cash was $16.01.
  • Balance sheet and debt: Total assets were $664.81 and stockholders’ equity was $152.49 at September 30. Repurchase agreements were $466.21, notes payable were $21.86, and no FHLBI advances remained. Total liabilities were $512.31. RMBS were $533.07 and servicing-related assets were $92.93.
  • Distributions: The company declared $1.47 per common share for the nine months and paid $11.06 in dividends during that period. Its REIT status generally requires annual distributions of at least 90% of REIT taxable income.

Changes versus comparable periods

  • Q3 returned to GAAP profitability from a substantial year-earlier loss, with stronger net interest and servicing income and a favorable derivative fair-value swing.
  • Nine-month GAAP earnings declined from $3.70 of net income to a $1.36 loss. The filing attributes significant pressure to servicing-asset valuation declines and derivative losses; net interest income also fell.
  • Servicing fee income increased substantially following the expansion of Aurora’s MSR portfolio. MSR unpaid principal balance was $3.43 billion at quarter-end, versus $2.02 billion at December 31, 2015; the fair value of MSRs was $27.96 million versus $19.76 million.
  • RMBS grew to $533.07 million from $508.24 million at year-end. Repurchase-agreement debt rose to $466.21 million from $385.56 million, while FHLBI advances were fully repaid from $62.25 million.

Outlook, risks and unusual items

  • Management gave no numerical earnings, portfolio, or dividend guidance. It said asset pricing had reduced available returns and that it intended to broaden investments to pursue a more diversified and stable revenue profile; execution requires capital, with no assurance as to when it can be raised.
  • Management expected cash on hand and operating cash flow to cover anticipated needs over the next 12 months, including potential margin calls and operating expenses. Repurchase financing is short term and uncommitted; quarter-end borrowings had a 51-day weighted-average remaining maturity and a 5.2% average haircut.
  • Interest-rate, spread, prepayment, and extension risks can affect funding costs, RMBS values, and servicing-asset cash flows. Servicing-related assets are Level 3 valuations based on models and significant assumptions; changes in prepayment speeds, discount rates, delinquencies, and servicing costs may materially affect reported values.
  • The company said rising rates were likely to reduce recapture activity, though it expected overall prepayment rates to remain roughly constant. It does not hedge changes in the fair value of servicing-related assets.
  • FHFA rules prevent the captive insurance subsidiary from obtaining new or renewing FHLBI advances; the company reports it no longer has access to that funding source. A new MSR facility with a $25 million maximum was established in September; it had no quarter-end balance, but Aurora borrowed approximately $14.1 million on October 3, 2016.
  • Freedom Mortgage is a key servicer, counterparty, and affiliate of the external manager. The filing notes that the related-party management agreement may be less favorable than an arm’s-length arrangement. Under a Ginnie Mae acknowledgement agreement, the company could be required to make certain payments if Freedom Mortgage fails to do so; management assessed material-loss risk as remote and recorded no liability.
  • The company recorded approximately $173,000 of other-than-temporary impairment on RMBS in 2016. Management reported no legal proceedings as of September 30 and no material change to previously disclosed risk factors.

Important facts for investors to verify

  • Reconcile the Q3 GAAP profit and nine-month GAAP loss with the non-GAAP core earnings measure, including the large servicing-asset and derivative valuation effects.
  • Assess the assumptions and sensitivity of Level 3 Excess MSR and MSR valuations, particularly prepayment, discount-rate, delinquency, and servicing-cost estimates.
  • Review short-term repo refinancing, collateral and margin-call exposure, and the replacement of FHLBI funding with other financing.
  • Monitor Freedom Mortgage servicing performance, affiliate relationships, and the potential obligations under the Ginnie Mae acknowledgement agreement.
  • Confirm the terms and use of the post-quarter $14.1 million MSR-facility borrowing, and whether management’s diversification plans obtain sufficient capital.
  • Compare declared dividends with taxable earnings, cash generation, and financing needs; GAAP earnings per share and taxable earnings can differ materially.