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Edited Transcript of CHMI earnings conference call or presentation 27-Feb-20 10:00pm GMT

Moorestown Mar 20, 2020 (Thomson StreetEvents) — Edited Transcript of Cherry Hill Mortgage Investment Corp earnings conference call or presentation Thursday, February 27, 2020 at 10:00:00pm GMT

* Jeffrey B. Lown

* Julian B. Evans

Cherry Hill Mortgage Investment Corporation – CFO, Treasurer, Secretary, Controller & Head of IR

B. Riley FBR, Inc., Research Division – Research Analyst

* Pierce J. Dever

Greetings. Welcome to the Cherry Hill Mortgage Investment Corporation Fourth Quarter and Full Year 2019 Earnings Conference Call. (Operator Instructions). As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Rory Rumore of Cherry Hill. Please proceed.

We’d like to thank you for joining us today for Cherry Hill Mortgage Investment Corporation’s Fourth Quarter 2019 Conference Call. In addition to this call, we have filed a press release that was distributed earlier this afternoon and posted to the Investor Relations section of our website at www.chmireit.com.

On today’s call, management’s prepared remarks and answers to your questions may contain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ from those discussed today. Examples of forward-looking statements include those related to interest income, financial guidance, IRRs, future expected cash flows as well as prepayment and recapture rates, delinquencies and non-GAAP financial measures such as core and comprehensive income. Forward-looking statements represent management’s current estimates, and Cherry Hill assumes no obligation to update any forward-looking statements in the future. We encourage listeners to review the more detailed discussions related to these forward-looking statements contained in the company’s filings with the SEC and the definitions contained in the financial presentations available on the company’s website.

Today’s conference call is hosted by Jay Lown, President and CEO; Julian Evans, the Chief Investment Officer; and Michael Hutchby, the Chief Financial Officer.

Now I will turn the call over to Jay.

Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [3]

Thanks, Rory, and welcome, everyone, to today’s call. We’re very pleased with Cherry Hill’s fourth quarter and 2019 performance. The quarter saw a moderating volatility as longer-term rates moved off the lows witnessed over the summer, the yield curve steepened slightly, and the mortgage base has improved. Prepayment fees, however, remained elevated throughout the quarter as originators closed out a record year for origination volume. Despite the accelerated prepayments which caused headwinds, we successfully managed our portfolio and delivered another quarter of solid core earnings while expanding our book value.

Overall, we’re confident in the current composition of our investment portfolio and our investment team’s risk management capabilities and believe we are well positioned to capture additional opportunities to extend our success into 2020.

Looking back on 2019, we encountered significant macroeconomic and geopolitical noise through much of the year. Broadly speaking, positive domestic economic data throughout the year was largely overshadowed by global trade disputes and the overhang of negative interest rates abroad, driven by tepid economic data from the EU in Asia. Largely due to the economic impact of the U.S.-China trade dispute, the Fed ended up shipping course and cut interest rates 3x in the second half of the year.

Our investment team navigated through that environment by actively managing our portfolio and utilizing a disciplined interest rate hedging strategy. As a result, we ended the year with our book value largely intact when compared to the prior year-end, which, in our view, was an excellent outcome given the various headwinds. Specifically, for the fourth quarter of 2019, we grew book value per share by 2% to $17.35 and generated core earnings of $0.48. In addition, we posted a 4.4% economic return for the quarter which brought our full year economic return to 8.8%, a meaningful accomplishment given the complex market environment we faced throughout the year.

Meanwhile, we opportunistically began executing on our previously announced share repurchase program. As of December 31, we repurchased approximately $3.5 million of common stock. We remain confident in our strategy to deliver shareholder value over the long term while maintaining the ability to continue repurchasing shares as appropriate. As we think about 2020, thus far, the coronavirus has gripped the markets amid uncertainty around the impact on global productivity. This has led interest rates to hit record lows in recent days. Although we believe, longer term, the volatility will ultimately work its way through the system, we remain highly committed to being flexible and responsive to market swings to enable us to navigate any prepayment volatility as we did in the back half of 2019. We believe that we’re properly positioned with our current asset composition and leverage, and look to book value preservation and long-term shareholder returns as our primary focus. More broadly in terms of our overall strategy, as we look forward into 2020, we remain committed to both our RMBS and MSR strategies and believe the 2 asset classes complement each other well and offer compelling returns in the low to mid-teens. Given our current size, we have been diligent about staying the course in that respect.

On the MSR front, we will continue to be selective in building and structuring our MSR portfolio through attractive flow acquisitions and bulk purchases that fit our needs. At the same time, on the RMBS side, we have a strong desire to mitigate our interest rate risk with respect to our agency portfolio through the purchase of specified pools that offer compelling refinance protection. As we’ve noted in the past, there are opportunities in the whole loan space that we believe would be accretive to shareholders and allow us to further diversify our business, assuming we’re in a position to grow the company. Ultimately, we will continue to be thoughtful in our approach to deploying capital and portfolio construction as we seek to create additional shareholder value. In short, I’m proud of the performance of our investment team for 2019, given the complex macroeconomic we encountered.

We began the year with the 10-year pushing 270 and a benign prepay environment. As the 10-year plunged to 146, prepayment speeds increased significantly. In addition, spread income compressed as the yield curve inverted during the summer, putting additional pressure on earnings. Throughout that turbulence cycle, our team took actions to preserve book value utilizing the proactive hedging strategy. Just as importantly, we are positioned to build off last year and succeed in 2020 and beyond. We will continue to take a proactive approach towards managing our portfolio, including continuing to add investments that will enable us to further withstand any increases in prepayment levels. We will also take advantage of opportunities that exist to add assets to the portfolio and reduce our overall risk exposure. We’re excited for our future and are positioned well for another year of building value for shareholders as we continue to execute on our strategy.

With that, I’ll turn the call over to Julian, who will cover more detailed highlights of our portfolio and its performance over the quarter.

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Julian B. Evans, Cherry Hill Mortgage Investment Corporation – CIO [4]

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Thank you, Jay. During the fourth quarter, U.S. and global rates rose, even with the Fed delivering their third and final interest rate ease of 2019. The interest rate rise in the quarter can be attributed to optimism surrounding the reduction of the U.S. and China trade tensions, which ultimately resulted in the signing of a Phase 1 trade agreement in early 2020. Based on these themes, all spread sector assets, including mortgages, outperformed hedges as interest rates rose and volatility declined in the fourth quarter.

As shown on Slide 5, servicing-related investments comprised of full MSRs, represented approximately 40% of our equity capital and approximately 10% of our investable assets, excluding cash at quarter end. Servicing assets increased as a percentage of equity from the previous quarter as improved MSR valuations increased the portfolio’s market value as well as some selective additions we made to the portfolio. Meanwhile, our RMBS portfolio accounted for approximately 57% of our equity, a 5% decline from the previous quarter. As a percentage of investable assets, RMBS represented approximately 90%, excluding cash at quarter end.

As of December 31, we held MSRs with a UPB of approximately $29 billion and a market value of approximately $291 million. Conventional and government MSR CPRs averaged approximately 22.3% and 15.5%, respectively, for the fourth quarter, both of which were marginally slower than in the prior quarter. The improvement in CPR speed is a function of interest rates and mortgage rates hitting low levels in September and rates subsequently bouncing to higher levels in November/December months, thus slowing prepayments. Additionally, winter seasonals and improved conventional recapture rates had an impact on speeds.

As of December 31, the RMBS portfolio stood at approximately $2.7 billion, as shown on Slide 7. Quarter-over-quarter, the RMBS portfolio’s composition continued to shift as capital was deployed. The 30-year securities position of the portfolio grew to 87%, up from approximately 85% as of September 30. And the remaining assets represented 13%. In the fourth quarter, the collateral composition of the RMBS portfolio posted a weighted average 3-month CPR of approximately 11.3%. Prepayment speeds accelerated further in the fourth quarter as homeowners locked in lower mortgage rates in the third quarter when U.S. interest rates touched near-term yearly lows.

For the fourth quarter, we posted a 0.73 RMBS NIM versus a 0.87 NIM for the third quarter. The reduction in NIM was due to the increased amortization which resulted from faster prepayment speeds which offset the reduction in repo and swap costs. Near term, we expect the NIM to fluctuate, but throughout 2020, we expect the NIM to maintain or improve based on continued improvements in asset financing levels, removal of higher cost interest rate swap positions and slower prepayments at the start of the year based on seasonals. The transition to improvement may take several months, and the recent interest rate movements driven by the lack of clarity surrounding the coronavirus may further delay this improvement.

At quarter end, the aggregate portfolio operated with leverage of approximately 6.1x and a positive duration gap. We ended the quarter with an aggregate portfolio duration gap of a positive 0.11 years. As we move forward, we will continue to evaluate and alter the portfolio as necessary.

I will now turn the call over to Mike for our fourth quarter financial discussion.

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Michael Andrew Hutchby, Cherry Hill Mortgage Investment Corporation – CFO, Treasurer, Secretary, Controller & Head of IR [5]

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Thank you, Julian. Our GAAP net income applicable to common stockholders for the fourth quarter was $5.2 million or $0.31 per weighted average share outstanding during the quarter, while comprehensive income attributable to common stockholders, which includes the mark-to-market of our held-for-sale RMBS, was $11.8 million or $0.70 per share. Our core earnings were $8.1 million or $0.48 per share. As Jay mentioned, our book value as of December 31 was $17.35, an increase of $0.34 per share from September 30 or 2% net of the fourth quarter 2019 dividend. We used a variety of derivative instruments to mitigate the effects of increases in interest rates on a portion of our future repurchase borrowings.

At the end of the fourth quarter, we held interest rate swaps, swaptions, TBAs and treasury futures, all of which had a combined notional amount of $2.8 billion. For GAAP purposes, we have not elected to apply hedge accounting for our interest rate derivatives. And as a result, we record the change in estimated fair value as a component of the net gain or loss on interest rate derivatives. Operating expenses were $3.4 million for the quarter, of which approximately $688,000 was related to our taxable REIT subsidiary.

On December 12, 2019, we declared a dividend of $0.40 per common share for the fourth quarter of 2019 which was paid on January 28, 2020. We also declared a dividend of $0.5125 per share on our 8.2% Series A cumulative redeemable preferred stock and a dividend of $0.515625 on our 8.25% Series B fixed-to-floating rate cumulative redeemable preferred stock, both of which were paid on January 15, 2020.

At this time, we will open up the call for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Tim Hayes with B. Riley.

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Michael Edward Smyth, B. Riley FBR, Inc., Research Division – Research Analyst [2]

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This is actually Mike on for Tim. Congrats on a great quarter. So my first question is what kind of levered returns are you seeing on MSRs versus RMBS.

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [3]

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Sure. I’ll let Ray answer that.

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Raymond Slater, Cherry Hill Mortgage Investment Corporation – Senior VP & MSR Portfolio Manager [4]

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Sure. So on the MSR front, I think the levered returns are in the low to mid-teens; unlevered, high single digits. Yes. That’s on flow.

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Julian B. Evans, Cherry Hill Mortgage Investment Corporation – CIO [5]

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And for the RMBS, we just take generic 3 is levered, let’s say, about 10x, you’re looking at something in the low to mid-teens.

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Michael Edward Smyth, B. Riley FBR, Inc., Research Division – Research Analyst [6]

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Got you. That’s helpful. And then just given where your stock is trading on pro forma or the new book side, how do you think about investing in MSRs versus MBS versus buying back stock at these levels?

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [7]

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Well, a week ago, we were trading at 95% of all books. So that’s a different discussion. But relative to the allocation between asset classes, Julian, I’ll let you take that.

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Julian B. Evans, Cherry Hill Mortgage Investment Corporation – CIO [8]

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Yes. I mean, look, I think that the — we’re continuously trying to figure out where the market wants to go in terms of absolute level of interest rate. The entry point, I think, for RMBS, specifically on some of the lower coupon mortgages is somewhat attractive. If we’re going to maintain at these rate levels over a foreseeable period of time. If rates were or have the ability to rise or the curve steepen on out, they have to assess that this is probably a decent entry point for MSRs.

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Michael Edward Smyth, B. Riley FBR, Inc., Research Division – Research Analyst [9]

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That’s helpful. And then just some of your peers recently decided to expand and get more active in credit. I know you hinted this on the call, but just given (inaudible) interest rate volatility, is this something you guys are taking a hard look at?

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [10]

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I would say that we get presented with a fair amount of opportunities in the space. And I think for us to do something, one, it would have to be accretive to returns; and two, it would have to be within the context of our experience and our ability to actually manage the assets. So when we think about that, we think about things more in the non-QM space than we do in the agency space. But as we do think about MSRs, we do think about origination, just generally speaking, around how to come up with a recapture machine that helps.

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Michael Edward Smyth, B. Riley FBR, Inc., Research Division – Research Analyst [11]

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That’s helpful. And then just one other question. So as you head into — as we’re in the seasonally weaker months, I’m just wondering how prepayments are looking so far in 1Q relative to historicals.

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Michael Andrew Hutchby, Cherry Hill Mortgage Investment Corporation – CFO, Treasurer, Secretary, Controller & Head of IR [12]

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Definitely seeing a bit of a slowdown with the winter seasonals. Obviously, that’s also have driving rates typically 45-day lag. So what we’re seeing in the market right now as far as levels of interest rates haven’t really shown up in closings yet for originators.

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Julian B. Evans, Cherry Hill Mortgage Investment Corporation – CIO [13]

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And I’ll just add a little thought in the sense that what we’ve seen at least in the first couple of months here for the RMS portfolio has been slower speeds out the gate, mainly based on seasonals. What we may start to see is in the second quarter, as Ray kind of mentioned, these things get locked in this month at these lower levels.

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Michael Edward Smyth, B. Riley FBR, Inc., Research Division – Research Analyst [14]

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That’s helpful. And then I’ll sneak one more in. Could you provide an intra-quarter book value update?

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [15]

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Okay. What I can tell you is that we looked at the book value on February 14. And on that date, the book value was approximately flat. And sorry, that’s inclusive of 2 months of dividend.

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Operator [16]

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Our next question comes from Trevor Cranston with JMP.

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Trevor John Cranston, JMP Securities LLC, Research Division – Director and Senior Research Analyst [17]

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Look, on the last question — so following up on the last question about the book value so far this quarter, I understand that, that update is as of mid-February. Can you guys give us a sense generically? And I know things are moving around pretty quickly. But do you have a sense of how MSR prices have changed or performed over the last several days as rates have declined pretty sharply?

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [18]

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Just broadly speaking about relative to what we think about paying for MSRs? Or the valuation?

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Trevor John Cranston, JMP Securities LLC, Research Division – Director and Senior Research Analyst [19]

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Yes. Both. If you have any color you could provide there would be helpful.

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [20]

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Well, we’re predominantly buying flow. So we don’t really have good color on anything related to bulk. And we haven’t really seen a whole lot of trades in that space. But I think broadly speaking, on the flow side, we’ve been taking down pricing on a regular basis.

Ray. Do you have any…

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Raymond Slater, Cherry Hill Mortgage Investment Corporation – Senior VP & MSR Portfolio Manager [21]

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Yes, I would say that pricing remains relatively fair. But keeping in mind that there’s convexity adjustments to these grids. So as we see par rates get reset lower, obviously, that’s going to reflect in adjusters backing off-price due to the market move.

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [22]

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Yes. With respect to flow, we get to refresh pricing frequently. So we feel pretty good about our ability to keep pace.

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Trevor John Cranston, JMP Securities LLC, Research Division – Director and Senior Research Analyst [23]

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Right. Got you. Okay. And as you think about the outlook for prepays going forward, if rates were to sort of stabilize around where they’re at currently, can you give us a sense as to where your expectations are in terms of where speeds on your portfolio would likely go relative to kind of where they came in, say, for the fourth quarter of ’19?

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Raymond Slater, Cherry Hill Mortgage Investment Corporation – Senior VP & MSR Portfolio Manager [24]

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Well, I mean obviously, it’s impossible to predict exactly where the CPRs are going to be in any given month. I would say that the portion of the portfolio that was highly refi-able since 6/30, we’ve seen a 20% decrease in that. Of course, some of that came back as recapture loan that you saw, the recapture rate did pop up. But the other thing to keep in mind is the burn-out on these are typically about a 25% decrease each time they see a cycle of a similar amount of incentive. So what the open item is what does loans that had a 4.25% note rate with their first chance to really refi with 50 bp incentive, what’s that going to do. Hard to say. It does appear that compared to just previous cycles that the refis pop up quicker but burn out faster as well.

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Trevor John Cranston, JMP Securities LLC, Research Division – Director and Senior Research Analyst [25]

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Okay, that’s helpful. And you guys mentioned that the recapture percentage went up in the fourth quarter. Can you provide any commentary around sort of if there’s any additional room for improvements in that number, assuming we do see refis start to pick up again going forward? Or if sort of that 10% level where it came in is sort of a reasonable way to think about it going forward?

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Raymond Slater, Cherry Hill Mortgage Investment Corporation – Senior VP & MSR Portfolio Manager [26]

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Yes. And keep in mind, too, that, that’s a quote off of total payoffs. So there’s always a portion of payoffs every month that are basically turnover, people just moving. So it’s not really reasonable to recapture much out of there. But in terms of recapture rate, we suspect that’ll be pretty much stable in the near term. We have enacted a more focused strategy on refi-ing the guys with the highest propensity to pay based on the payment savings. And we think that’s shown an improvement from Q3 and Q4.

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Operator [27]

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Our next our next question comes from Henry Coffey with Wedbush.

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Henry Joseph Coffey, Wedbush Securities Inc., Research Division – MD of Equities Research [28]

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Yes, 2 questions. You talked about a recapture arrangement. Those seem to only work if you own the person or the organization responsible for doing that. Is that feasible? Or would it be more of a partnership like you’ve had in the past?

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [29]

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So the first thing I’d say is if Ginnie recapture rates are very different than conventional recapture rates, as I think you know. And I think that with respect to the absolute number, we dig deeper. And the portfolio is broken out by servicer, and the collateral characteristics between the 2 servicers are different. Given the collateral characteristics of each portfolio, we’ve become increasingly more comfortable with their efforts to help us recapture our loans. And I would say that the Roundpoint portfolio has a higher gross note rate, and we see significantly higher recapture rate from them than we do Flagstar who has a lower gross note rate on their portfolio. So while the absolute number may not be impressive to you, we’re pretty happy with the fact that the percentages are increasing, and we look forward to being able to give you guys more color on the first quarter in a couple of months.

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Henry Joseph Coffey, Wedbush Securities Inc., Research Division – MD of Equities Research [30]

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So you’re happy with the partnerships. They’re actually working. I mean…

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [31]

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Look, do you always want more recapture, Henry? Sure. I think [we’re about] to get every loan that we possibly could. I think originators are a lot more efficient about refinancing loans today than they were 1 or 2 years ago. But given the relationships that we have and the partnerships that we have and the communication around their efforts on our portfolio, we have gotten more comfortable with their efforts over the last 6 months. I can tell you, 6 months ago, no, I wasn’t very happy with it. But given the recent results that I’ve seen, much more comfortable.

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Henry Joseph Coffey, Wedbush Securities Inc., Research Division – MD of Equities Research [32]

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So you don’t have to go to the extreme of “buying somebody.” The partnerships are working. I guess the other question is…

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [33]

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Hold on, I didn’t say that. But I think I alluded to the fact that if we looked at an originator, it would be with the goal of being able to do just that, which is to be more in control of your recapture. And I think that is probably the best scenario you have. But at our size, what we have, we think, works well for us.

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Henry Joseph Coffey, Wedbush Securities Inc., Research Division – MD of Equities Research [34]

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So — and then on the — it’s a little shocking looking at where rates are. Forgetting what’s going on in the MSR side, is there a reinvestment issue on the horizon for you? Or can you sort of live comfortably with where things are, with where your dividend is? Obviously, you’ve got a nice earnings buffer in there that wasn’t there before. The yield curve is looking a little funky. When you look at rates today, is there a spread issue or reinvestment problem as you put new money to work?

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Julian B. Evans, Cherry Hill Mortgage Investment Corporation – CIO [35]

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Well, Henry, it’s Julian. We’ve — clearly, we’ve come down to these low level of rates very quickly. I would not be surprised if some of this reverse just as quickly. It would be nice to always be able to put money to work, I think, at higher levels of interest rates. Given where we are currently, we’re able to put things to work in the mid-teens. But we’ll have to wait and see in terms of where prepayments, where financing costs as well as where swap rates kind of wind out. I think we feel comfortable where we are currently with our dividend and where our core expectations are at the current moment in time.

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Operator [36]

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Our next question comes from Kevin Barker with Piper Sandler.

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Pierce J. Dever, Piper Sandler & Co., Research Division – Research Analyst [37]

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This is actually Pierce Dever on for Kevin. So a lot of my questions have been answered but maybe a quick one on the buyback. I was just wanting to get a gauge of, I guess, your appetite to use the remaining $6.5 million or so, I guess it is, of authorization and how you’re thinking about kind of deploying capital via this manner going forward?

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [38]

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Sure. So we believe that we put that program in place to execute it. I think we’ve had a few other things on our mind this week relative to just the volatility in the marketplace. But at 80% to 85% of book, it’s a compelling discussion. But I can’t give you an absolute number as to what we do. I think we’ve had a lot of work to do this week just to keep on top of the markets. But to your point, we put the program in place. We’ve shown that we’re willing to execute on it, and we’re just trying to be smart about how we do it.

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Operator [39]

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We have a follow-up question from Trevor Cranston with JMP.

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Trevor John Cranston, JMP Securities LLC, Research Division – Director and Senior Research Analyst [40]

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Just one more thing related to the movement in rates we’ve had recently. You guys have talked about being dynamic in your approach to hedging and trying to protect book value. Can you disclose any significant changes you’ve made to the hedge book or the portfolio since the end of the year?

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [41]

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Yes. I’ll take some of that. We have made some changes. I mean, obviously, throughout the rate rally, we have continuously adjusted this portfolio. It does not remain constant. I would say some of the things that we have done, we have moved into lower coupon mortgages, a combination of TBA as well as spec pools. In addition, we’ve also taken the opportunity to reset some of our payer swaps, as interest rates have rallied. And in addition to that, we’ve also added duration via treasuries futures.

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Michael Andrew Hutchby, Cherry Hill Mortgage Investment Corporation – CFO, Treasurer, Secretary, Controller & Head of IR [42]

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I think our goal is pretty much unchanged, Trevor, which is to be fairly neutral, given the lack of conviction about where rates are going. That really hasn’t changed.

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Operator [43]

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At this time, I would like to turn the call back over to management for closing comments.

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Jeffrey B. Lown, Cherry Hill Mortgage Investment Corporation – President, CEO & Director [44]

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Great. Thank you, everybody, for joining us on today’s call, and we look forward to updating you soon on our first quarter results. Have a great evening.

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Operator [45]

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This concludes today’s teleconference. You may disconnect your lines at this time, and have a great evening.

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