Cherry Hill Mortgage Investment Corporation — Q3 2014 Form 10-Q
Reporting period: Three and nine months ended September 30, 2014. The company invests primarily in residential mortgage-backed securities (RMBS) and excess mortgage servicing rights (Excess MSRs). It began operating after its October 2013 IPO, so 2013 comparisons largely reflect a pre-operating period and are not directly comparable.
Financial performance and position
| Metric | Q3 2014 | Nine months 2014 |
|---|---|---|
| Interest income | $6.244 million | $18.392 million |
| Interest expense | $1.164 million | $3.117 million |
| Net interest income | $5.080 million | $15.275 million |
| Net income | $2.814 million | $2.893 million |
| Net income applicable to common stockholders | $2.788 million; $0.37 per share | $2.866 million; $0.38 per share |
| Comprehensive income | $0.844 million | $9.873 million |
Q3 total income was $4.078 million after $1.002 million of net other losses, including a $2.050 million unrealized loss on Excess MSRs, partly offset by $2.025 million of unrealized derivative gains. For the nine months, total income was $6.614 million; net other losses were $8.661 million, principally reflecting $5.407 million of net derivative losses and a $3.028 million Excess MSR valuation loss, partly offset by $6.980 million of RMBS unrealized gains recorded in other comprehensive income.
At September 30, total assets were $495.663 million, including $375.622 million of RMBS and $96.022 million of Excess MSRs. Repurchase-agreement debt was $329.239 million; cash and cash equivalents were $13.486 million, with a further $6.299 million restricted. Total equity was $159.873 million. The company reported an RMBS debt-to-equity ratio of approximately 6.3:1.
The disclosed weighted-average RMBS asset yield was 3.03%, weighted-average interest expense 1.48%, and net interest spread 1.55%, versus a 1.43% spread at year-end 2013. Repurchase borrowings carried a 0.36% weighted-average rate after swaps, with a 61-day weighted-average remaining maturity and a 5.4% weighted-average collateral haircut.
For the nine months, operating cash flow was $21.536 million, investing cash flow was negative $71.845 million, and financing cash flow was positive $53.420 million. Cash increased $3.111 million to $13.486 million. Operating cash flow includes significant noncash fair-value and other adjustments.
Changes and notable items
- RMBS carrying value rose from $286.979 million at December 31, 2013 to $375.622 million; the portfolio grew from 29 to 47 securities. The company reported no other-than-temporary impairment charges.
- Excess MSR carrying value declined from $110.306 million to $96.022 million. Management attributed the Q3 Pool 1 fair-value decline primarily to actual prepayments exceeding modeled speeds; Pool 2 value increased during the quarter.
- Repurchase debt increased from $261.302 million to $329.239 million. Shareholders’ equity was $159.873 million, compared with $161.122 million at year-end.
- The company declared a Q3 dividend of $0.51 per common share, paid October 28, 2014. Dividends declared for 2014 through Q3 totaled $1.52 per share.
- Q3 2014 net income followed a $0.655 million net loss in Q2 2014. The prior-year periods are not meaningful operating comparisons: the company had not commenced operations by September 30, 2013.
Outlook, risks and contingencies
Management expected cash on hand and operating cash flow to meet anticipated liquidity needs over the next 12 months, including current portfolio financing, flow purchases of Excess MSRs, potential margin calls and operating costs. No earnings or dividend forecast was provided. Management said future leverage would vary with portfolio characteristics, financing availability and market conditions.
- Funding and liquidity: Repurchase agreements are short-term and generally uncommitted; lenders can demand additional collateral as asset values change. Management stated liquid assets were sufficient for short-term recourse liabilities.
- Rate, spread and prepayment exposure: Rising rates may increase borrowing costs and reduce RMBS values; faster prepayments may reduce Excess MSR cash flows and values. A modeled 100-basis-point rate increase implied an RMBS value decline of about $18.4 million. The filing’s sensitivity tables are hypothetical, not forecasts.
- Valuation uncertainty: Excess MSRs are Level 3 assets valued using discounted cash flows and significant unobservable assumptions, including prepayment rates, uncollected payments and discount rates.
- Servicer and related-party dependence: Freedom Mortgage services the underlying loans and is affiliated with the externally managed company through common control. If Freedom Mortgage is terminated as servicer, the company’s rights to related Excess MSR cash flows may terminate. The management agreement provides a 1.5% annual fee based on defined stockholders’ equity and may require a termination fee.
- Other exposures: The company has potential obligations under Ginnie Mae acknowledgment arrangements if a servicer fails to make required payments; management assessed material loss as remote and accrued no liability. No legal proceedings or material legal accruals were reported.
- The company is a REIT and must meet qualification and distribution requirements. Failure to qualify could result in material tax consequences. Management reported effective disclosure controls and no material change in internal control during the quarter.
As a subsequent event, CHMI Solutions had obtained licenses in 15 of the 17 states it considered necessary to purchase and sell closed residential mortgage loans and hold servicing rights, as of November 7, 2014.
Investor verification points
- Review the assumptions behind Level 3 Excess MSR valuations, especially prepayment speeds, discount rates and recapture performance.
- Assess reliance on short-maturity, uncommitted repo funding, collateral haircuts, margin-call capacity and the reported 6.3:1 RMBS debt-to-equity ratio.
- Reconcile reported net income with derivative and Excess MSR fair-value changes, and distinguish GAAP earnings from cash available for dividends.
- Examine the Freedom Mortgage servicing, recapture and related-party management arrangements, including termination provisions and fees.
- Confirm REIT qualification, dividend coverage and the status of remaining state licensing and other approvals for CHMI Solutions.