MFA Financial, Inc. (MFA) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by, and welcome to MFA Financial Announces Second Quarter 2023 Earnings. [Operator Instructions] As a reminder, today's conference is being recorded. And I will now turn the conference over to our host, Mr. Hal Schwartz. Please go ahead, sir.

Thank you, operator, and good morning, everyone. The information discussed on this conference call today may contain or refer to forward-looking statements regarding MFA Financial, Inc., which reflect management's beliefs, expectations and assumptions as to MFA's future performance and operations. When used, statements that are not historical in nature, including those containing words such as will, believe, expect, anticipate, estimate, should, could, would or similar expressions are intended to identify forward-looking statements. All forward-looking statements speak only as of the date on which they are made. These types of statements are subject to various known and unknown risks, uncertainties, assumptions and other factors, including those described in MFA's annual report on Form 10-K for the year ended December 31, 2022, and other reports that it may file from time to time with the Securities and Exchange Commission. These risks, uncertainties and other factors could cause MFA's actual results to differ materially from those projected, expressed or implied in any forward-looking statements it makes. For additional information regarding MFA's use of forward-looking statements, please see the relevant disclosure in the press release announcing MFA's second quarter 2023 financial results. Thank you for your time. I would now like to turn this call over to MFA's CEO and President, Craig Knutson.

Thank you, Hal. Good morning, everyone, and thank you for joining us here today for MFA Financial's Second Quarter 2023 Earnings Call. Also with me today are Steve Yarad, our CFO; Gudmundur Kristjansson; and Bryan Wulfsohn, our Co-Chief Investment Officers and other members of senior management. The interest rate environment in the second quarter of 2023 was another volatile one with rates grinding higher for most of the quarter, 2-year treasuries were below 4% early in the second quarter after rallying in the aftermath of the banking crisis in March. However, as the fear of additional banking fallout began to fade, the bond market finally seemed to capitulate and begin to take Fed Chair Powell's consistent message to heart. We don't hear so much about the false optimism of a rate cut later this year and bond yields, particularly 2 years, moved higher throughout the quarter to reflect this reality. 2-year treasuries ended the quarter almost 100 basis points higher, and the 2- 10-year inversion widened from about 50 basis points at the beginning of the quarter to about 100 basis points at the end of the quarter. This inverted curve, together with general interest rate volatility continued to make levered investing in fixed income and in mortgages, in particular, very challenging. That said, MFA's risk management discipline and strategic initiatives have enabled us to weather this storm extraordinarily well. Our net interest rate spread increased by 40 basis points from 1.74% to 2.14% during the second quarter despite this challenging backdrop as we have for several quarters now, effectively locked in our funding cost through securitization and interest rate swaps. The yield on our interest-earning assets increased by 41 basis points, while our interest expense increased by only 1 basis point. We added almost $1 billion of new investments in the second quarter as we continue to add assets at progressively higher yields. Our distributable earnings for the second quarter was $0.40, which comfortably exceeded our $0.35 dividend. Our book value was up modestly in the second quarter, but this should not be a big surprise as we have consistently communicated that our net portfolio duration gap has been about 1. This duration exposure led to a book value increase in the first quarter and to a book value decline in the second quarter, and we generated a total economic return for the first half of the year of 2%. As we illustrate on Page 10 of our earnings deck, our book value was driven overwhelmingly by the higher interest rate impact on the fair value of our loan portfolio, which is marked at a substantial discount to par. Despite the fact that the fair value of these loans is below par, the principal that we receive, whether through payoffs, curtailments or simply scheduled monthly principal payments are received at par. We're very pleased with our portfolio credit metrics as we saw loan delinquencies declined during the second quarter in each of our major asset classes. The substantial seasoning of much of this portfolio and current LTV of 59% provide a solid credit backstop that supports the expectation that this principal will be repaid at par. Although the future interest rate outlook is far from certain, it appears that the Fed is at or at least near to the end of the rate tightening cycle. And the consensus at this point seems to be that the Fed will hold rates steady for at least the next few quarters to give the economy and markets the necessary time to fuel the cumulative impact of 525 basis points of tighter monetary policy. Fortunately, we continue to benefit from the hard work we did in late 2021 and early '22, which effectively fixed our funding costs while we now have attractive investment opportunities to add new assets at very accretive yields. As we show on Page 7 of our earnings deck, very few of our $3 billion of interest rate swaps mature before the fourth quarter of 2024. Finally, our wholly owned business purpose loan originator, Lima One, continues to shine, producing successively higher volume levels of high-yielding and high-quality assets. We cannot emphasize enough the inimitable value that this captive originator delivers to MFA shareholders. Not only does it provide a steady and substantial source of internally generated assets, but the significance of the integrated nature of this arrangement is evident in loan performance. One of the underappreciated benefits of a captive originator versus a more broad and fragmented aggregator strategy is that Lima One underwrites these loans, they service the loans, they manage the construction draws, and most importantly, they have a relationship with the borrowers. Now this is not to suggest that loans will not go delinquent. This is always a risk, but we uniquely control our own outcome and there is no conflict of interest between the originator servicer and the investor because we all live under the same roof. And I'll now turn the call over to Gudmundur to talk about portfolio activity and additionally about Lima One.

Thanks, Craig. Second quarter acquisitions increased by approximately 60% compared to the first quarter as we added approximately $1 billion of loans and securities and grew our investment portfolio by 5% to about $8.9 billion. Business purpose and non-QM loans accounted for majority of our acquisitions at approximately $900 million. These loans had an average coupon of approximately 9.5% and a strong credit profile with average LTV of 68% and average FICO of 734. We also continued to execute on our Agency MBS strategy and added about $100 million of Agency MBS in the quarter. That portfolio now stands at about $400 million. And as we discussed last quarter, we believe that Agency MBS yields and spreads are attractive here on a stand-alone basis but that they also provide risk management benefits to our credit-focused portfolio by improving portfolio liquidity and having the potential to perform well during periods of economic softness. Given current financing levels, we expect that return on equity will be around mid-teens for the second quarter additions, and that continues to be the case for assets that we are adding in the third quarter. Significantly higher interest rates and wider credit spreads today compared to the late 2020 through early 2022 period are providing us with a great opportunity to add attractive assets to our portfolio. A combination of prudent risk management and strategic decisions have put us in a position to take advantage of this environment. First, our significant interest rate hedging activities in late 2021 and early 2022 combined with active securitizations of our whole loans have helped us maintain substantial liquidity and a strong balance sheet. Second, our strategic acquisition of Lima One in 2021 provides us with the capacity to create high-quality and high-yielding business purpose loans in size. This combination of liquidity and access to attractive assets has in the last 3 quarters allowed us to acquire about $1.9 billion of loans with an average coupon of approximately 9.5%. As Craig highlighted in his opening remarks, we are seeing the benefits of these acquisitions in our yield on interest-earning assets which increased 41 basis points compared to the first quarter and is up 135 basis from a year ago to 6.1% in the second quarter. The increase in asset yields, combined with the relative stability of our funding costs, increased our portfolio spread to 214 basis points in the second quarter, up 40 basis points compared to the first quarter and up 77 basis points from a year ago. The economy continues to be resilient and seems to have coped well with a significant market volatility from the regional banking crisis and the debt-ceiling standoff in the second quarter, with the first read on second quarter GDP coming in above expectations of 2.4% and the labor market remaining resilient with the unemployment rate hovering around 3.5% for the last 15 months. The housing market has also surprised many by showing resilience in the face of higher mortgage rates, with low inventory levels proving to be a strong counterweight to low affordability. National home prices declined about 3% in the second half of last year, but the housing recession appears to be over for now with national home prices rising about 2% year-to-date. These trends, combined with inflation steadily trending down, have improved the outlook for the economy in the short to the medium term and raise the probability that the Fed may be close to the end of this hiking cycle, but also that they may keep rates elevated for longer. This creates a favorable backdrop for our credit-focused portfolio as delinquencies and loss severities are less likely to deteriorate when the labor market is strong and home prices are rising. In addition, the current high-yielding investment environment may last longer if the Fed is about to settle in around current Fed fund levels for some time and let the lagged effect of monetary policy work its way through the system. Turning to Lima One. Lima One had a really strong quarter and continued to show its importance to our investment strategy. Lima originated approximately $584 million of business purpose loans in the second quarter, a 50% increase from the first quarter and has originated about $4.3 billion of business purpose loans for our balance sheet since our acquisition 2 years ago. Similar to the last few quarters, the majority of origination was focused on the short-term transitional loans, which accounted for about 85% of second quarter origination. Demand for Lima's products and services remained strong, with disruptions in the private lending space and less competition from regional banks providing opportunities to grow market share and attract talent in this space. The third quarter is off to a good start, with July origination volume of approximately $215 million, and we expect the third and fourth quarters each to have over $600 million of origination. Credit quality remains fundamental to our BPL strategy and the credit statistics on Lima's second quarter origination remained strong with average LTV of 66% and average FICO score of 738 on loans originated. The 60-plus day delinquency rate on our BPL loans originated by Lima One remained exceptionally low at 2.2% in the second quarter. Lima services all the loans they originate in-house and have a highly experienced construction management team that reviews all construction budgets and has an active hand in loss mitigation activities. We believe this is a huge advantage in the BPL space, which combined with our investment strategy and credit culture has led to excellent credit performance. I will now turn the call over to Bryan Wulfsohn, who will discuss MFA's securitization activities and portfolio credit performance in more detail.

Thanks, Gudmundur. The story in the securitization markets remain the same in the second quarter. Rate volatility remained elevated, which generally leads to spread widening with the counterbalancing force being limited technical supply picture. We issued one securitization backed by non-QM collateral in the second quarter. In connection with that securitization, we sold $300 million UPB in May prior to the rates back up in June, locking in a 6.1% cost debt. And although we did not issue a securitization backed by transitional loans in the quarter, the 2 outstanding revolving deals previously issued continued to provide significant benefits as we now have recycled over $300 million of loans into those structures. Recently, we have seen a tightening in securitization spreads as rate volatility has calmed down and absence of supply continues to provide a tailwind. Spreads on AAAs for recent deals in the market are closing in on the tights for the year seen earlier in January. We expect to come to market again in the third quarter and continue to believe that mortgage securitization will be an important part of our business strategy as it provides for nonrecourse, non-mark-to-market financing, which will further insulate the portfolio from volatile markets. Moving to our credit performance. We saw improvement over the second quarter across our loan portfolio. 60-plus day delinquencies in our purchased performing loans decreased to 2.8% from 3.1% in the first quarter. The components of that portfolio being the non-QM, transitional loan and SFR portfolios, all showing improvement. 60-plus day delinquencies in our legacy RPL/NPL portfolio also improved by over 3 points from the prior quarter, down to 27.4%. This improvement resulted from a combination of liquidating previously delinquent loans as well as reviving delinquent loans back to current status through active asset management. Our asset management team has deep experience working through distressed situations to the benefit of our investors. We have now successfully worked out over $3 billion in loans, which we believe puts us in a unique position to be able to take advantage of potential opportunities in addition to limiting losses in times of economic stress. Prepayment speeds on our purchase performing portfolio increased moderately from the prior quarter. Our legacy RPL portfolio CPR increased almost 3% from the previous quarter, and our legacy NPL portfolio had a significant increase of over 10% to 14 CPR. These increases were expected as seasonality impacts from real estate transaction activity tends to push fees in the spring. Total paydowns for the quarter were over $400 million, which were reinvested into loans carrying a coupon approximately 250 basis points higher. Lastly, we continue to take advantage of the strong housing market, reducing our REO portfolio, which continues to shrink as fewer properties are entering REO status and are being sold out of the portfolio. Over the quarter, we sold 95 properties for $32 million, resulting in $4 million in gains. We believe the low LTV of our portfolio combined with prudent credit underwriting, have our portfolio well positioned for the current economic environment. And with that, I'll turn the call over to the operator for questions.

[Operator Instructions] We will go to the line of Bose George with KBW.

Actually, can we get to ask just about your duration gap that you've noted? It's been a year. How do you kind of arrive at that level and versus being more neutral?

Yes. Bose, thank you. Yes. So we've kind of been around that level for some time. We tightened up a little last year, obviously, as we mentioned, when we put on the interest rate swaps and hedges. So late '21 and '22, we did a lot of our hedging as well as for securitization activities. The way we've thought about it is, as rates have risen, it feels appropriate to have some duration in our portfolio. Most of our hedges are on the front end of the curve. So we have effectively isolated the impact of rising rates on our cost of funds. And that was really our emphasis to make sure that like we would stabilize the spread and our cost of funds over the long term. As rates are now probably reaching close to the end of the hiking cycle for the Fed, it feels like you're supposed to respect both sides of the risk here. The fact that, look, the Fed could go a little bit higher, but with inflation trending down, we're probably at a point in time where the effects of economic policy -- sorry, the effects of Fed policy are working its way through the system. And so we think having a balanced portfolio where we hedge the front end but then have some duration that could potentially benefit from a declining rates is the right approach there. Well, keep in mind, the duration of one is fairly low in the context of probably the space because keep in mind, our leverage is only about 3.9x, and so really, the impact on equity is always the leverage times the duration. And then the other thing is majority of our returns come from credit and credit exposure. And credit spreads are pretty wide. And so in the event that the economy continues to stay resilient, we do think we have a lot of benefits from the credit side of the portfolio, which is not necessarily reflected just in the duration.

Okay. Great. Yes, that makes a lot of sense. And then just switching to just the opportunities that could arise from some of the turmoil at the banks, can you just talk about spots where you could potentially see areas to deploy capital?

Sure. So we and you have heard a lot about bank capital rule changes recently and how that could open investment opportunities for mortgage REITs. And this is certainly possible. But I think some of that optimism is probably a little bit premature. We see the portfolios that are described as for sale. But in many cases, the sellers of prime jumbo loans with low interest rates are not willing or able to sell these pools at market prices. In addition, in most of these cases, there would be bank sellers. They really want to maintain their relationship with the borrower. So their preference would be to retain the servicing even if they sell the loans. And this can also create challenges for a buyer such as ourselves who would want to use securitization as a financing strategy because many of these banks are not set up to properly service to a securitization. So now pricing expectations could line up with reality in the future, and obviously, the operational friction can be overcome, but this will likely take some time. And finally, I'll point out that, Bose, we're focused on primarily non-QM loans and business purpose loans for the last 5 years. And I think that came from a belief that these loan classes offered superior risk-adjusted investment returns, but we also identified a very strategic component of this investment strategy and namely, that was because there was very little competition for banks for these loans. So I don't think it's by accident that those are the loans that we focused on. There could be some opportunities going forward, but at least thus far, I think there are some real challenges to banks selling loans at market prices.

Yes. Bose, I would just add, in terms of the Lima One and the kind of the BPL origination side, we are feeling some benefits on the margin from lack of competition from regional banks. Those banks definitely would compete in some of the transitional loans called fix-and-flip construction loans. And so to the extent that their balance sheet is constrained as well as potentially higher capital requirements on them, we're definitely feeling some benefits on that. I mean it's not a transformational thing, but on the margin, it's definitely making Lima's life easier to attract borrowers.

Our next question will come from the line of Steve Delaney of JMP Securities.

Congrats on the strong distributable EPS figure of $0.40. Reading in the deck, I was curious about the economic book value decline of about 5% to 6%. But I see you're -- in the deck, you're attributing that to just higher interest rates. We've -- compared to where we were in the second quarter, whichever -- where the bonds are today better than I, but we're -- on average, we're probably up 50 basis points. I'm curious if you've put any additional interest rate swaps on your portfolio in the last couple of months to try to protect book value.

Sure. Thanks for the question, Steve. So in answer to your question, no, we have not added additional interest rate swaps. But if we look at where the price changes were in the second quarter, I think they're exactly where you expect them to be. The majority of loan prices that led to that book value decline were non-QM loans, which were probably down 1.75 points or so and single-family rental loans, which are probably down about 2 points or so. So again, I don't think it's a big surprise. And as Gudmundur said, we do see the overall interest rate risk being a little more balanced than we certainly did a year ago.

And just to add to that, we performed the securitization of 9 term loans in May, and we didn't take off any hedges when we execute on that securitization. So -- and the majority of the assets that we added were much shorter in nature being the BPL loans. So we didn't really think -- it made a ton of sense to add a bunch of hedges in the quarter, but we obviously reevaluate that on a day-to-day basis.

Yes. And that's a good point. I point out like 85% of Lima's origination was in the shorter-term transitional loans.

Yes. And those transitional loans, do you actually float the rate? Or is it just the short-term nature of the loan that you might have a fixed coupon, but a short duration?

Yes, it is the short-term nature of them. So they are of a fixed rate coupon. So it is the short-term nature of them. And so as you've seen, if you look through our deck, the coupon has been coming up every single quarter substantially. And like if you look at our pipeline currently, we say the coupon in the pipeline is above 10%, but that's a blended coupon. So if you just look at the transitional loans, you're probably closer to 10.5% or 10.5% to 10.75%, something like that in terms of coupon. So that's what's coming on, on the books, and those are short assets. And we continue to see paydowns in that book. As we said like the CPR is about 42 3-month CPR on the transitional loans, but the paydown which is a substantial paydown in terms of principal received. And that's, as Bryan pointed out, the paydown was about 7%, the coupon that came off.

Got it. Okay. Do you have handy a distributable return on equity figure for the second quarter that you've calculated?

I'm sorry, Steve?

Do you have a distributable earnings -- return on equity using distributable earnings for the second quarter?

So I guess we can calculate it. So annualized, it's probably 10%, 11% on book value.

That's close enough. I just -- that will give us a good target to kind of just have in mind as we're updating model and such. And okay, well, look, good dividend coverage, $0.40 over $0.35. It sounds like the portfolio is only improving in terms of yields. So keep it in the middle of the road, guys. It's -- you're in a good place.

Thank you, Steve.

Thanks, Steve.

We'll go next to the line of Doug Harter with Credit Suisse.

Looking at Slide 10, which shows the potential upside to economic book value, can you talk about where most of -- which assets most of that discount sits in? And kind of how should we think about the duration of those assets or the time that it might take to recover that discount?

So I would just say off the top of my head that the majority of that is going to be in non-QM loans and in single-family rental loans. And what do you think in terms of average life for...

Yes. I mean the average life would be around 4 to 5 years kind of for the portfolio as a whole. And as Craig pointed out, most of the discount is probably in the non-QM, single-family rental as well as some of the PCD loans as well because they were sort of the longer-duration assets that would have declined the most in valley as rates rose. And as you think about the portfolio, the average life is probably 5 years on these longer assets for the entire portfolio is around 4 years.

Got it. And I guess, does that any of that discount kind of get accreted back into distributable earnings or kind of as those loans pay off, that's just going to show up in book value?

Just for the carrying value assets, are we going to accrete?

So the discount for the fair value won't go into distributable earnings as it gets backed out, right? But as the accounting value earns increase in value, that probably gets reflected in the yield if we get additional payoffs or additional returns or cash flows on those loans that we would...

Yes. So like the payoffs should definitely be reflected in the book value because we're getting principal back at par, okay? To the extent that we acquired assets at a discount and they pay off, that would be reflected in a higher yield, too. So those would be 2 components. But to think that our fair value, as Steve was pointing out, that goes through income statement, just as rates go up or down.

Earnings but not in distributable earnings.

That's right.

And we'll go next to the line of Eric Hagen with BTIG.

Actually, fleshing that conversation out maybe just a little bit more, like what would be the impact in marking the securitized debt to market if rates were to drop in that duration or to shorten on the non-QM portfolio? Like what would that look like? Is there any -- are there any kind of -- is there any optionality on the liability side that would -- we should think about when rates drop?

Well, so we show on that Page 10, right, we show there's a great bar. That's the discount for the securitized debt, the discount to par because we have to net that against the assets. Because obviously, our plan is that we're going to pay back all that securitized debt at par. So even though some of those AAA bonds that we sold at less than 1% yields might be worth in the low 80s, those are going to get repaid at par.

Do you feel like there could be an opportunity to call and resecuritize any of the non-QM deals that you did like the ones shortly after the pandemic if spreads come in a lot more from here?

I mean there certainly are opportunities to call them. I mean I think generally, it's probably a 3-year call period. But again, we'll have to balance the outstanding cost of the outstanding securities versus where we could reissue.

Right. And another one here on Lima One. I mean do you have the unfunded commitment in the -- below Lima One portfolio? And over what kind of time frame that gets distributed?

Yes. I think we show the portfolio look at Page 12, we show the UPB and the maximum loan amounts. And so the difference of the 2 would be the unfunded commitment. So it's about $480 million or so -- sorry, $580 million. And the way that, that really works is just kind of in the normal course of business. As draws happen, it's akin to quote buying a new loan. And so we fund that on our warehouse lines and in our transitional loan securitization in a normal course of business. As Bryan pointed out, for example, in our revolving securitizations, they're $400 million, but that's what we funded on day 1. Then subsequently, we've done $330 million additional has rolled through that deal because as stuff pays off, you fund new things. And the new things we're funding are both new acquisitions as well as draws on those loans. And then the other thing is the draw rate on our portfolio is equivalent to about 30 CPR, but the paydown is equivalent to about 42 CPR. So effectively, we're -- this is organically funded just through our paydowns on the transitional loan portfolio as well as just through our warehouse lines and the securitizations.

And the securitized loan self-fund within the securitization.

That's right.

Yes. On the RTL securitization, can you remind us how much time is left on the revolving period? Do you have that?

Yes. So the first one, we did that in May of last year. So we have another year left on that roughly. And then we did one in February of this year, which was -- so that leaves another 1.5 years on them.

[Operator Instructions] Speakers, there are no further questions in queue from the phones.

All right. Thank you, everyone, for your interest in MFA Financial. Enjoy the rest of your summer, and we look forward to our next update when we announce third quarter results in November.

Thank you. And ladies and gentlemen, this conference is available for replay beginning at 1:00 p.m. Eastern Time today and running through November 4 at midday. You may access the AT&T replay system at any time by dialing 1 (866) 207-1041 and entering the access code of 2399106. International dialers may call (402) 970-0847. Those numbers again are 1 (866) 207-1041 or 1 (402)-970-0847 with the access code of 2399106. That does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing. You may now disconnect.