MFA Financial, Inc. (MFA) Q1 2023 Earnings Call Transcript

MFA Financial, Inc. (NYSE:MFA) Q1 2023 Earnings Conference Call May 4, 2023 10:00 AM ET

Company Participants

Harold Schwartz - SVP, General Counsel & Secretary

Craig Knutson - President, CEO & Director

Gudmundur Kristjansson - SVP & Co-CIO

Bryan Wulfsohn - SVP & Co-CIO

Conference Call Participants

Steven Delaney - JMP Securities

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the MFA First Quarter 2023 Earnings Conference Call. [Operator Instructions].

I would now like to turn the conference over to our host, Harold Schwartz. Please go ahead.

Harold Schwartz

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 first 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.

Craig Knutson

Thank you, Hal. Good morning, everyone, and thank you for joining us here today for MFA Financial's First 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 first quarter of 2023 started on a promising note with treasuries rallying modestly and credit spreads becoming progressively more constructive through the month of January. This utopia was short-lived, however, when a blowout payroll number on February 3 shot yields sharply higher. Two-year treasury sold off nearly 100 basis points through the month of February as the bond market priced an additional expected Fed tightening. Then queue up the banking crisis of 2023 in early March as Silicon Valley Bank and Signature Bank were shut down over the weekend of March 11 and 12. Two-year treasuries rallied over 100 basis points between March 8 and March 13. And any notion that bond market volatility was just a 2022 phenomenon was quickly dispelled.

As if we did not have enough to worry about with persistently high inflation numbers of Fed that is still very focused on inflation and a geopolitical environment that has not improved in the last year, we now add concerns of banking sector liquidity and possible asset sales to the mix. It's difficult to know in what inning the banking crisis is but it's very clear that banks will be less willing to extend credit for at least the short term and quite possibly longer. As Fed Chair, Powell, has acknowledged in press conferences, reduced bank lending will tighten financial conditions, which could do some of the work for the Fed in its effort to curb inflation, but the magnitude of these impacts is unknowable at this time. Long story short, the market volatility we experienced last year is not over. While we certainly could not have anticipated many of the specific events that have occurred over the last year, we did take steps to protect MFA from a higher-rate environment beginning over a year ago, and our results in the first quarter of 2023 are a testament to our risk management positioning in preparation. Our economic book value was up 3% in the first quarter, and we generated an economic return of 5.3% in what was a very challenging period for mortgage REITs.

We took advantage of a brief constructive period in the securitization market early in the first quarter and executed 3 securitizations collateralized by $668 million of loans. Together with the 9 securitizations we did in 2022 and our $3 billion interest rate swap book, we continued to have effectively fixed our cost of funds. In the face of 10 fed funds hikes in an aggregate amount of 500 basis points since March of 2022, our cost of funds has increased by less than 60 basis points over the last 3 quarters. And as rates have trended up, the yield on our purchased performing loan portfolio has increased by almost 120 basis points over the same period. New purchases today, and for the foreseeable future, are at substantially higher yields that should continue to increase our interest rate spread.

Our interest rate swap position, which we assembled early in 2022 before and in the very early stages of Fed tightening, generated $22 million of positive carry in the first quarter, and the positive carry is now in excess of 350 basis points. Now admittedly, the swap position and the securitizations that we executed over at least the first half of 2022 increased our effective cost of funds and reduced our interest rate spread at the time, particularly in the second quarter of 2022. But this early pain positioned MFA to avoid much more material spread compression in the last half of 2022 and thus far in 2023.

Our loan portfolio does expose MFA to credit risk and that these loans are not guaranteed by the U.S. government, but the credit fundamentals of our loan portfolio are strong with a weighted average current LTV at quarter end of 59%. And importantly, not only is the overall LTV low, but the tail of higher LTV loans is very small and almost entirely comprised of loans we purchased years ago at substantial discounts to par. So our LTV to purchase price is considerably lower than the LTV to UPB. Page 9 of our earnings deck illustrates these credit metrics.

Portfolio delinquencies are also quite low and actually decreased modestly in the first quarter. On Page 10 of our earnings deck, we provide the components of potential upside in MFA's economic book value as our loan portfolio is marked substantially below par. This mark is overwhelmingly due to rising interest rates rather than to weakening credit fundamentals. As borrowers repay principal either through scheduled amortization, curtailments or payoffs, we recoup these discounts to par. Netting the loan portfolio discount to par with the securitized debt discount to par, we have over $2.50 per share of potential economic book value upside.

Now it seems clear to us that the Fed is neither certain about the need of further rate increases nor clear on how long they'll need to hold rates at restrictive levels in order to break inflation. Our rate strategy remains in place as it has been since the second quarter of last year. We'll continue to prioritize liquidity. Our cash position was over $360 million at quarter end. We'll continue to securitize loans and will adjust market pricing and yields on our asset purchases to reflect current market rates and funding costs.

And I'd now like to turn the call over to Gudmundur to discuss our portfolio activity and Lima One.

Gudmundur Kristjansson

Thanks, Craig. We continue to take advantage of the attractive investment landscape and acquired approximately $630 million of loans and securities in the first quarter, growing our portfolio by 6% to about $8.4 billion at the end of the quarter. We believe the current environment of rapid monetary policy tightening, where market participants have had to grapple with high volatility, lack of liquidity and reduced access to leverage, benefits experienced market participants like MFA that have managed leveraged mortgage assets through various cycles and have the ability to source their own high-quality credit assets in size. The combination of high interest rates, wide spreads and our unique ability to source loans continues to provide us with great opportunities to add high-yielding loans to our balance sheet. This is especially apparent with our originator, Lima One, where we remain one of the few companies that can create our own high-quality business purpose loans in size. We added over $450 million of loans in the quarter with an average coupon of approximately 10% and excellent credit characteristics, with average LTV of 66% and average FICO score of 744. $364 million or about 80% of our loan additions were business purpose loans originated by Lima One, which is where we continue to find the best opportunities to deploy capital. With current warehouse and securitization levels, we see return on equity around mid-teens for the first quarter additions, and that continues to be the case for loans that we're currently adding in the second quarter.

We also opportunistically added about $174 million of Agency MBS in the latter part of the quarter when spreads had widened substantially from earlier in the quarter, bringing our total holdings of Agency MBS to about $300 million at the end of the quarter. Our holdings are concentrated in and 5.5s, which offer a combination of high liquidity and attractive spreads, and we see the expected return on equity of Agency MBS around low to mid-teens at current levels. Agency MBS currently yields over 5%, and you have to go back to 2008 to find yields as high. While the nominal spread over the 10-year treasury is currently above 165 basis points and has only been wider during 2 periods in the last 20 years, during the great financial crisis in 2008 and in October and November of last year. We believe that Agency MBS yields and spreads are attractive here but also that Agency MBS 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 and offsetting potential challenges in our credit portfolio during such periods.

Turning to Lima One and our business purpose loan origination activities. Lima One continued to perform well and show its importance to our asset acquisition strategy. They originated approximately $380 million in the first quarter and accounted for about 80% of our loan additions in the quarter. Origination volumes were only modestly down from the fourth quarter and probably a little better than expected considering the lagged effects of our higher rate -- of higher rates and tighter underwriting standards that we implemented in 2022 and the fact that the first quarter is usually the slowest quarter for BPL lending. Importantly, origination trends in the quarter were encouraging with March volumes being strong at around $170 million, and that momentum has carried into April and May, setting us up for higher origination volumes in the second quarter.

Continued market volatility and reduced access to capital and leverage for many BPL originators has allowed Lima to continue to increase market share and attract talent. We believe this, combined with MFA's balance sheet strength will allow Lima to continue to grow origination volume throughout this year. Our focus on credit quality remains fundamental to our BPL strategy and the credit statistics on Lima's first quarter originations remained strong with average LTV of 65% and average FICO score of 747 on loans originated. The combination of strong credit characteristics and Lima servicing expertise continues to deliver excellent results with the 60-plus day delinquency rate on MFA's BPL loans originated by Lima at around 2%.

As the outlook for the economy continues to shift and the odds of an economic decline cannot be ignored, we believe it is important for owners of credit-sensitive loans to understand their servicing capability and capacity in a potential economic downturn. With Lima One, we have a highly experienced BPL servicer that has all servicing and construction and asset management in-house. We believe this, combined with MFA's own extensive credit and asset management experience, allows us to respond quickly to changing circumstances and gives us a unique ability to manage a potential increase in borrower delinquencies more effectively than most other players in the BPL space.

We continue to be focused on liquidity and availability of financing to support our BPL origination and, to that end, expanded our RTL financing capacity by over $400 million in the quarter by issuing our second revolving transitional loan securitization as well as increasing non-mark-to-market warehouse capacity by $250 million. We also issued our 6 investor loan securitization in February, where we securitized over $200 million of Lima One-originated loans.

Our BPL securitizations continue to be well received in the marketplace, and we believe we have created a unique BPL securitization program where origination, servicing, asset management and risk retention are all under one roof. We think this will be a competitive advantage for us in the future, especially on the transitional loan securitizations, where a clear alignment of interest and superior credit performance would lead to better access to the securitization markets.

I will now turn the call over to Bryan Wulfsohn, who will discuss MFA's securitization activities and portfolio credit performance in more detail.

Bryan Wulfsohn

Thanks, Gudmundur. The securitization market, like all markets, continued to exhibit volatility in the first quarter. Our valiant spreads and rates in January offered an opportunity to execute at attractive borrowing costs relative to the fourth quarter of 2022. We were able to issue over $500 million in bonds through 3 securitizations, 1 each backed by Non-QM, SFR, transitional loans in the first 2 months of the quarter prior to the bank turmoil in March, which resulted in spread widening. On a positive note, securitization execution levels have the tailwind of a tactical supply picture, which continues to be an important force in helping spreads narrow this year. Expected annual supply of non-agency residential bond issuance is forecasted to be less than half of the volume from the prior year.

We're pleased to report that over the quarter, 23 bonds issued from our securitization program were upgraded by rating agencies. These upgrades were across our non-QM and SFR platforms and are another positive illustration of our continued focus on credit. Looking ahead, we believe that mortgage securitization will continue to 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. Our strategy of targeting high-FICO borrowers and an emphasis on lower LTVs and our loan originations and acquisitions have created a resilient portfolio to weather uncertain economic environments. Our credit quality remained strong through the first quarter, 60-plus day delinquencies in our purchased performing portfolio were unchanged from the prior quarter at 3%. The components of that portfolio being non-QM, transitional loan and SFR portfolios all remained unchanged. The 60-plus day delinquencies in our legacy RPL/NPL portfolio improved slightly from the prior quarter down to 30.6%. Prepayment speeds on our portfolios are relatively unchanged from the prior quarter. The non-QM and SFR portfolios exhibited a 3-month CPR of 8% and 5%, respectively, and a 3-month CPR for our legacy RPL portfolio was unchanged. Transitional loan portfolio 3-month repayment rate increased to 40%. With the spring selling season upon us, we wouldn't be surprised to see prepayment rates increase modestly in Q2.

Lastly, we continue to have success with our REO portfolio. It continues to shrink as fewer properties are entering REO status than are being sold out of the portfolio. Over the quarter, we sold 93 properties for $34 million, resulting in $5 million in gains. Overall, we believe the credit in our portfolio is well positioned for the current economic environment.

And with that, I'll turn the call over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question is from Steve Delaney from JMP Securities.

Steven Delaney

Congrats on the strong start to 2023. It sounds like Lima is just kind of on fire down there. You were talking about quarter-over-quarter, year-over-year for 1Q. Are you at a point at this point in May, where you can give us some sense of what your estimated range for origination volume from Lima might be for 2023? And how that would compare to 2022 on a full year basis?

Gudmundur Kristjansson

Thanks, Steve. No, it's a great question. Yes, we're very happy with how Lima is performing and some of the things that are creating challenges in the marketplace currently, the volatility, the reduced access to leverage and some of the banking turmoil, and we think that continues to create good opportunities for Lima One as they lend in the business purpose space. And so as we think about the volume, yes, we think volume will continue to increase throughout the year. Based on what we're seeing, March, April, May, probably Q2 is going to be, let's say, around $500 million, probably a little shy of $500 million. And we would expect, as we go into the second half of the year, we kind of get back to a run rate of perhaps $600 million a quarter. And so if you add that up $500 million for Q2 and $600 million each quarter in the second half of the year, we're probably looking at around $2 billion for full 2023 and so I think that's kind of a modest expectation. And yes, I think there's room for upside, too, depending on how the market evolves, but we think that's a really good performance in the context of kind of a challenging backdrop in the overall market.

Steven Delaney

Great. Remind me, Gudmundur, what 2022 was. I'm sure it's in my model. I just -- I don't have that open.

Gudmundur Kristjansson

Yes, it was $2.3 billion.

Steven Delaney

$2.3 billion, so down just a touch and obviously, a higher rate market, for sure. And we were pleasantly surprised to be beaten on your book value number, up 3%. to $16. Can you comment -- Craig, you mentioned $2.50 of per share discount accretion. When we think about 1Q, obviously, you had discount accretion but were there actually -- were you observing any secondary trades, market price indications that was there any positive price adjustment on which you own in addition to your discount?

Craig Knutson

Yes, Steve, thanks for the question. So the answer is yes. There was some price appreciation during the quarter. The loan book overall, I would say, was probably up 1.5 points or so. Obviously, we gave some of that back on the hedges that we had and on the securitized debt. So that's really how the book value shook out. I mean overall, I think it was primarily due to rates and I think we showed at the end of the fourth quarter that we had a positive duration. So it wasn't necessarily a big surprise. But those are sort of the key components.

Operator

[Operator Instructions]. And at this time, no one is queuing up for a question.

Craig Knutson

All right. Well, thank you, operator. Thanks, everyone, for listening today, and we'll look forward to our next update in August.

Operator

Thank you. And ladies and gentlemen, this conference is available for replay beginning at 12 Eastern today, running through August 5 at midnight. You may access the AT&T replay system by dialing 866-207-1041 and entering the access code 6223657. International callers can dial 402-970-0847.

And that does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing. You may now disconnect.