| Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations. |
The following discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes included in “Part I, Item 1. Consolidated Financial Statements” of this Quarterly Report on Form 10-Q.
General
We are a public residential real estate finance company focused on acquiring, investing in and managing residential mortgage assets in the United States. We were incorporated in Maryland on October 31, 2012, and we commenced operations on or about October 9, 2013 following the completion of our initial public offering and a concurrent private placement. Our common stock, our 8.20% Series A Cumulative Redeemable Preferred Stock (our “Series A Preferred Stock”) and our 8.250% Series B Fixed-to-Floating Rate Cumulative Redeemable Preferred Stock (our “Series B Preferred Stock”) are listed and traded on the New York Stock Exchange under the symbols “CHMI,” “CHMI-PRA” and “CHMI-PRB,” respectively. We are externally managed by our Manager, Cherry Hill Mortgage Management, LLC, an SEC-registered investment adviser.
Our principal objective is to generate attractive current yields and risk-adjusted total returns for our stockholders over the long term, primarily through dividend distributions and secondarily through capital appreciation. We attempt to attain this objective by selectively constructing and actively managing a portfolio of Servicing Related Assets (as defined below) and residential mortgage-backed securities (“RMBS”) and, subject to market conditions, other cash flowing residential mortgage assets.
We are subject to the risks involved with real estate and real estate-related debt instruments. These include, among others, the risks normally associated with changes in the general economic climate, changes in the mortgage market, changes in tax laws, interest rate levels, and the availability of financing.
We elected to be taxed as a REIT for U.S. federal income tax purposes commencing with our short taxable year ended December 31, 2013. We operate so as to continue to qualify to be taxed as a REIT. Our asset acquisition strategy focuses on acquiring a diversified portfolio of residential mortgage assets that balances the risk and reward opportunities our Manager observes in the marketplace. Aurora has or is in the process of obtaining the licenses necessary to invest in mortgage servicing rights (“MSRs”) on a nationwide basis and is an approved seller/servicer for Fannie Mae and Freddie Mac.
In addition to Servicing Related Assets, we invest in RMBS, primarily those backed by 30-, 20- and 15-year fixed rate mortgages that offer what we believe to be favorable prepayment and duration characteristics. Our RMBS consist primarily of Agency RMBS on which the payments of principal and interest are guaranteed by an Agency. We have also invested in collateralized mortgage obligations guaranteed by an Agency (“Agency CMOs”) consisting of interest only securities (“IOs”) as well as non-Agency collateralized mortgage obligations that are either risk-sharing securities issued by Fannie Mae or Freddie Mac or private label securities that are issued by a non-government related entity. We finance our RMBS with an amount of leverage, that varies from time to time depending on the particular characteristics of our portfolio, the availability of financing and market conditions. We do not have a targeted leverage ratio for our RMBS. Our borrowings for RMBS consist of short-term borrowings under master repurchase agreements.
Subject to maintaining our qualification as a REIT, we utilize derivative financial instruments (or hedging instruments) to hedge our exposure to potential interest rate mismatches between the interest we earn on our assets and our borrowing costs caused by fluctuations in short-term interest rates. In utilizing leverage and interest rate hedges, our objectives include, where desirable, locking in, on a long-term basis, a spread between the yield on our assets and the cost of our financing in an effort to improve returns to our stockholders.
We also operate our business in a manner that permits us to maintain our exclusion from registration as an investment company under the Investment Company Act.
Effective January 1, 2020, Cherry Hill Operating Partnership LP, the Company’s operating partnership subsidiary (the “Operating Partnership”), contributed substantially all of its assets to CHMI Sub-REIT, Inc. (the “Sub-REIT”) in exchange for all of the common stock of the Sub-REIT. As a result of this contribution, the Sub-REIT is a wholly-owned subsidiary of the Operating Partnership and operations formerly conducted by the Operating Partnership through its subsidiaries are now conducted by the Sub-REIT through those same subsidiaries. The Sub-REIT has elected to be taxed as a REIT under the Code commencing with its taxable year ended December 31, 2020.
On March 29, 2017, the Company issued and sold 5,175,000 shares of common stock, par value $0.01 per share, raising approximately $81.1 million after underwriting discounts and commissions but before expenses of approximately $229,000. All of the net proceeds were used to invest in RMBS.
On August 17, 2017, the Company issued and sold 2,400,000 shares of its Series A Preferred Stock, raising approximately $58.1 million after underwriting discounts and commissions but before expenses of approximately $193,000. All of the net proceeds from the Series A Preferred Stock offering were also invested in RMBS.
In April 2018, the Company initiated an at-the-market offering program (the “Preferred Series A ATM Program”) pursuant to which it may offer through one or more sales agents and sell from time to time up to $35.0 million of its Series A Preferred Stock at prices prevailing at the time, subject to volume and other regulatory limitations. The Company did not issue and sell any shares of the Series A Preferred Stock during the three and nine-month periods ended September 30, 2021 and the year ended December 31, 2020.
On June 4, 2018, the Company issued and sold 2,750,000 shares of its common stock. The underwriters subsequently exercised their option to purchase an additional 338,857 shares for total proceeds of approximately $53.8 million after underwriting discounts and commissions but before expenses of approximately $265,000. All of the net proceeds were invested in RMBS.
In August 2018, the Company initiated an at-the-market offering program (the “Common Stock ATM Program” and, together with the Preferred Series A ATM Program, the “ATM Programs”)) pursuant to which it may offer through one or more sales agents and sell from time to time up to $50.0 million of our common stock at prices prevailing at the time, subject to volume and other regulatory limitations. During the three and nine-month period ended September 30, 2021, the Company issued and sold 553,500 shares of common stock under the Common Stock ATM Program. The shares were sold at a weighted average price of $8.97 per share for gross proceeds of approximately $5.0 million before fees of approximately $99,000. The Company did not issue and sell any common stock under the Common Stock ATM Program during the year ended December 31, 2020.
On February 11, 2019, the Company issued and sold 1,800,000 shares of its Series B Preferred Stock. The underwriters subsequently exercised their option to purchase an additional 200,000 shares for total proceeds of approximately $48.4 million after underwriting discounts and commissions but before expenses of approximately $285,000. The net proceeds from the Series B Preferred Stock offering were invested in RMBS and MSRs.
In September 2019, the Company initiated a share repurchase program that allows for the repurchase of up to an aggregate of $10.0 million of its common stock. Shares may be repurchased from time to time through privately negotiated transactions or open market transactions, pursuant to a trading plan in accordance with Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or by any combination of such methods. The manner, price, number and timing of share repurchases are subject to a variety of factors, including market conditions and applicable SEC rules. The share repurchase program does not require the purchase of any minimum number of shares, and, subject to SEC rules, purchases may be commenced or suspended at any time without prior notice. During the three and nine-month periods ended September 30, 2021, the Company did not repurchase any common stock pursuant to the repurchase program. During the year ended December 31, 2020, the Company repurchased 142,531 shares of its common stock pursuant to the repurchase program for approximately $1.8 million.
A significant portion of the paydowns of the RMBS acquired as a result of these equity offerings has been deployed into the acquisition of MSRs. The Company may also sell certain of these RMBS and deploy the net proceeds from such sales to the extent necessary to fund the purchase price of MSRs.
Recent Developments
The COVID-19 pandemic continues to create substantial uncertainty for government policy makers and the Federal Reserve Board with consequent effects on the economy in the United States. While the economy has largely reopened, the increased presence of highly contagious variants, and particularly the Delta variant, of the virus has exacerbated supply chain issues that arose during the shutdown of various economies. Certain forbearance programs and prohibitions on foreclosures have been extended while others have expired adding to the concern of the consequences once all such programs end. As of September 30, 2021, 2.4% of borrowers on loans underlying the MSRs owned by Aurora are reflected as being in an active forbearance program, with 6.3% of those borrowers continuing to make their regular scheduled monthly payment. The Company continues to maintain an elevated level of unrestricted cash due to the continuing uncertainty regarding government policy and the economy. Based on information currently available to the Company, the Company continues to believe that it will be able to satisfy all of its servicing obligations in 2021.
Factors Impacting our Operating Results
Our income is generated primarily by the net spread between the income we earn on our assets and the cost of our financing and hedging activities as well as the amortization of any purchase premiums or the accretion of discounts. Our net income includes the actual interest payments we receive on our RMBS, the net servicing fees we receive on our MSRs and the accretion/amortization of any purchase discounts/premiums. Changes in various factors such as market interest rates, prepayment speeds, estimated future cash flows, servicing costs and credit quality could affect the amount of premium to be amortized or discount to be accreted into interest income for a given period. Prepayment speeds vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. Our operating results may also be affected by credit losses in excess of initial anticipations or unanticipated credit events experienced by borrowers whose mortgage loans underly the MSRs held by Aurora or the non-Agency RMBS held in our portfolio.
Set forth below is the positive net spread between the yield on RMBS and our costs of funding those assets at the end of each of the quarters indicated below:
Average Net Yield Spread at Period End
| Quarter Ended | | Average Asset Yield | | | Average Cost of Funds | | | Average Net Interest Rate Spread | |
| September 30, 2021 | | | 2.94 | % | | | 0.63 | % | | | 2.31 | % |
| June 30, 2021 | | | 2.94 | % | | | 0.62 | % | | | 2.32 | % |
| March 31, 2021 | | | 3.04 | % | | | 0.53 | % | | | 2.52 | % |
| December 31, 2020 | | | 3.05 | % | | | 0.59 | % | | | 2.46 | % |
The Average Cost of Funds also includes the benefits of related swaps.
Changes in the Market Value of Our Assets
We hold our Servicing Related Assets as long-term investments. Our MSRs are carried at their fair value with changes in their fair value recorded in other income or loss in our consolidated statements of income (loss). Those values may be affected by events or headlines that are outside of our control, such as the COVID-19 pandemic and other events impacting the U.S. or global economy generally or the U.S. residential market specifically, and events or headlines impacting the parties with which we do business. See “Part I, Item 1A. Risk Factors – Risks Related to Our Business” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020.
Our RMBS are carried at their fair value, as available-for-sale in accordance with ASC 320, Investments – Debt and Equity Securities. Beginning on January 1, 2020, upon adoption of Accounting Standards Update (“ASU”) 2016-13, Financial Instruments-Credit Losses, we evaluate the cost basis of our RMBS on a quarterly basis under ASC 326-30, Financial Instruments-Credit Losses: Available-for-Sale Debt Securities. When the fair value of a security is less than its amortized cost basis as of the balance sheet date, the security’s cost basis is considered impaired. If we determine that we intend to sell the security or it is more likely than not that we will be required to sell before recovery, we recognize the difference between the fair value and amortized cost as a loss in the consolidated statements of income (loss). If we determine we do not intend to sell the security or it is not more likely than not we will be required to sell the security before recovery, we must evaluate the decline in the fair value of the impaired security and determine whether such decline resulted from a credit loss or non-credit related factors. In our assessment of whether a credit loss exists, we perform a qualitative assessment around whether a credit loss exists and if necessary, we compare the present value of estimated future cash flows of the impaired security with the amortized cost basis of such security. The estimated future cash flows reflect those that a “market participant” would use and typically include assumptions related to fluctuations in interest rates, prepayment speeds, default rates, collateral performance, and the timing and amount of projected credit losses, as well as incorporating observations of current market developments and events. Cash flows are discounted at an interest rate equal to the current yield used to accrete interest income. If the present value of estimated future cash flows is less than the amortized cost basis of the security, an expected credit loss exists and is included in provision (reversal) for credit losses on securities in the consolidated statements of income (loss). If it is determined as of the financial reporting date that all or a portion of a security’s cost basis is not collectible, then we will recognize a realized loss to the extent of the adjustment to the security’s cost basis. This adjustment to the amortized cost basis of the security is reflected in realized gain (loss) on RMBS, available-for-sale, net in the consolidated statements of income (loss).
Impact of Changes in Market Interest Rates on Our Assets
The value of our assets may be affected by prepayment rates on mortgage loans. Prepayment speed is the measurement of how quickly borrowers pay down the unpaid principal balance (“UPB”) of their loans or how quickly loans are otherwise liquidated or charged off. Generally, in a declining interest rate environment, prepayment speeds tend to increase. Conversely, in an increasing interest rate environment, prepayment speeds tend to decrease. When we acquire Servicing Related Assets or RMBS, we anticipate that the underlying mortgage loans will prepay at a projected rate generating an expected cash flow (in the case of Servicing Related Assets) and yield. If we purchase assets at a premium to par value and borrowers prepay their mortgage loans faster than expected, the corresponding prepayments on our assets may reduce the expected yield on such assets because we will have to amortize the related premium on an accelerated basis. In addition, we will have to reinvest the greater amounts of prepayments in that lower rate environment thereby affecting future yields on our assets. If we purchase assets at a discount to par value, and borrowers prepay their mortgage loans slower than expected, the decrease in corresponding prepayments may reduce the expected yield on assets because we will not be able to accrete the related discount as quickly as originally anticipated.
If prepayment speeds are significantly greater than expected, the fair value of the Servicing Related Assets could be less than their fair value as previously reported on our consolidated balance sheets. Such a reduction in the fair value of the Servicing Related Assets would have a negative impact on our book value. Furthermore, a significant increase in prepayment speeds could materially reduce the ultimate cash flows we receive from the Servicing Related Assets, and we could receive substantially less than what we paid for such assets. Our balance sheet, results of operations and cash flows are susceptible to significant volatility due to changes in the fair value of, or cash flows from, the Servicing Related Assets as interest rates change.
A slower than anticipated rate of prepayment due to an increase in market interest rates also will cause the life of the related RMBS to extend beyond that which was projected. As a result, we would have an asset with a lower yield than current investments for a longer period of time. In addition, if we have hedged our interest rate risk, extension may cause the security to be outstanding longer than the related hedge, thereby reducing the protection intended to be provided by the hedge.
Voluntary and involuntary prepayment rates may be affected by a number of factors including, but not limited to, the availability of mortgage credit, the relative economic vitality of, or natural disasters affecting, the area in which the related properties are located, the servicing of the mortgage loans, possible changes in tax laws, other opportunities for investment, homeowner mobility and other economic, social, geographic, demographic and legal factors, none of which can be predicted with any certainty.
We attempt to reduce the exposure of our MSRs to voluntary prepayments through the structuring of recapture agreements with Aurora’s subservicers. Under these agreements, the subservicer attempts to refinance specified mortgage loans. The subservicer sells the new mortgage loan to the applicable Agency, transfers the related MSR to Aurora and then subservices the new mortgage loan on behalf of Aurora. See “Part I, Item 1. Notes to Consolidated Financial Statements—Note 7. Transactions with Related Parties” for information regarding Aurora’s recapture agreements.
With respect to our business operations, increases in interest rates, in general, may over time cause:
| • | the interest expense associated with our borrowings to increase; |
| • | the value of our assets to fluctuate; |
| • | the coupons on any adjustable-rate and hybrid RMBS we may own to reset, although on a delayed basis, to higher interest rates; |
| • | prepayments on our RMBS to slow, thereby slowing the amortization of our purchase premiums and the accretion of our purchase discounts; and |
| • | an increase in the value of any interest rate swap agreements we may enter into as part of our hedging strategy. |
Conversely, decreases in interest rates, in general, may over time cause:
| • | prepayments on our RMBS to increase, thereby accelerating the amortization of our purchase premiums and the accretion of our purchase discounts; |
| • | the interest expense associated with our borrowings to decrease; |
| • | the value of our assets to fluctuate; |
| • | a decrease in the value of any interest rate swap agreements we may enter into as part of our hedging strategy; and |
| • | coupons on any adjustable-rate and hybrid RMBS assets we may own to reset, although on a delayed basis, to lower interest rates. |
Effects of Spreads on our Assets
The spread between the yield on our assets and our funding costs affects the performance of our business. Wider spreads imply the potential for greater income on new asset purchases but may have a negative impact on our stated book value. Wider spreads may also negatively impact asset prices. In an environment where spreads are widening, counterparties may require additional collateral to secure borrowings which may require us to reduce leverage by selling assets. Conversely, tighter spreads imply the potential for lower income on new asset purchases but may have a positive impact on stated book value of our existing assets. In this case, we may be able to reduce the amount of collateral required to secure borrowings.
Credit Risk
We are subject to varying degrees of credit risk in connection with our assets. Although we expect relatively low credit risk with respect to our portfolios of Agency RMBS, we are subject to the credit risk of borrowers under the loans backing any CMOs that we may own and to the credit enhancements built into the CMO structure. We also are subject to the credit risk of the borrowers under the mortgage loans underlying the MSRs that Aurora owns. Through loan level due diligence, we attempt to mitigate this risk by seeking to acquire high quality assets at appropriate prices given anticipated and unanticipated losses. We also conduct ongoing monitoring of acquired MSRs. Nevertheless, unanticipated credit losses could occur which could adversely impact our operating results.
Critical Accounting Policies and Use of Estimates
Our financial statements are prepared in accordance with US GAAP, which requires the use of estimates that involve the exercise of judgment and the use of assumptions as to future uncertainties. In accordance with SEC guidance, the following discussion addresses the accounting policies that we apply with respect to our operations. Our most critical accounting policies involve decisions and assessments that could affect our reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, as well as our reported amounts of revenues and expenses. We believe that the decisions and assessments upon which our financial statements are based were reasonable at the time made and based upon information available to us at that time. Our critical accounting policies and accounting estimates may be expanded over time as we diversify our portfolio. The material accounting policies and estimates that we expect to be most critical to an investor’s understanding of our financial results and condition and require complex management judgment are discussed below.
Classification of Investment Securities and Impairment of Financial Instruments
ASC 320, Investments – Debt and Equity Securities, requires that at the time of purchase, we designate a security as either trading, available-for-sale, or held-to-maturity depending on our ability and intent to hold such security to maturity. Securities available-for-sale will be reported at fair value, while securities held-to-maturity will be reported at amortized cost. Although we may hold most of our securities until maturity, we may, from time to time, sell any of our securities as part of our overall management of our asset portfolio. Accordingly, we elect to classify all of our RMBS as available-for-sale. All assets classified as available-for-sale will be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity. See “–Fair Valued Assets and Liabilities.”
Beginning on January 1, 2020, upon adoption of ASU 2016-13, Financial Instruments-Credit Losses, we evaluate the cost basis of our RMBS on a quarterly basis under ASC 326-30, Financial Instruments-Credit Losses: Available-for-Sale Debt Securities. When the fair value of a security is less than its amortized cost basis as of the balance sheet date, the security’s cost basis is considered impaired. If we determine that we intend to sell the security or it is more likely than not that we will be required to sell before recovery, we recognize the difference between the fair value and amortized cost as a loss in the consolidated statements of income (loss). If we determine we do not intend to sell the security or it is not more likely than not we will be required to sell the security before recovery, we must evaluate the decline in the fair value of the impaired security and determine whether such decline resulted from a credit loss or non-credit related factors. In our assessment of whether a credit loss exists, we perform a qualitative assessment around whether a credit loss exists and if necessary, we compare the present value of estimated future cash flows of the impaired security with the amortized cost basis of such security. The estimated future cash flows reflect those that a “market participant” would use and typically include assumptions related to fluctuations in interest rates, prepayment speeds, default rates, collateral performance, and the timing and amount of projected credit losses, as well as incorporating observations of current market developments and events. Cash flows are discounted at an interest rate equal to the current yield used to accrete interest income. If the present value of estimated future cash flows is less than the amortized cost basis of the security, an expected credit loss exists and is included in provision (reversal) for credit losses on securities in the consolidated statements of income (loss). If it is determined as of the financial reporting date that all or a portion of a security’s cost basis is not collectible, then we will recognize a realized loss to the extent of the adjustment to the security’s cost basis. This adjustment to the amortized cost basis of the security is reflected in realized gain (loss) on RMBS, available-for-sale, net in the consolidated statements of income (loss).
Fair Valued Assets and Liabilities
ASC 820, Fair Value Measurements and Disclosures, defines fair value as the price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices available in active markets (i.e., observable inputs) and the lowest priority to data lacking transparency (i.e., unobservable inputs). Additionally, ASC 820 requires an entity to consider all aspects of nonperformance risk, including the entity’s own credit standing, when measuring the fair value of a liability.
ASC 820 establishes a three-level hierarchy to be used when measuring and disclosing fair value. An instrument’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. Following is a description of the three levels:
| • | Level 1 inputs are quoted prices in active markets for identical assets or liabilities as of the measurement date under current market conditions. Additionally, the entity must have the ability to access the active market and the quoted prices cannot be adjusted by the entity. |
| • | Level 2 inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs that are observable or can be corroborated by observable market data by correlation or other means for substantially the full-term of the assets or liabilities. |
| • | Level 3 unobservable inputs are supported by little or no market activity. The unobservable inputs represent the assumptions that management believes market participants would use to price the assets and liabilities, including risk. Generally, Level 3 assets and liabilities are valued using pricing models, discounted cash flow methodologies, or similar techniques that require significant judgment or estimation. |
The level in the fair value hierarchy within which the entirety of a fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. We have used Level 2 for our RMBSs, our derivative assets and liabilities and Level 3 for our Servicing Related Assets.
When available, we use quoted market prices to determine the fair value of an asset or liability. If quoted market prices are not available, we will consult independent pricing services or third-party broker quotes, provided that there is no ongoing material event that affects the issuer of the securities being valued or the market. If there is such an ongoing event, or if quoted market prices are not available, we will determine the fair value of the securities using valuation techniques that use, when possible, current market-based or independently-sourced market parameters, such as interest rates.
Investments in MSRs
We have elected the fair value option to record our investments in MSRs in order to provide users of our consolidated financial statements with better information regarding the effects of prepayment risk and other market factors on the MSRs. Under this election, we record a valuation adjustment on our investments in MSRs on a quarterly basis to recognize the changes in fair value of our MSRs in net income as described below. As an owner and manager of MSRs, we may be obligated to fund advances of principal and interest payments due to third-party owners of the underlying loans, but not yet received from the individual borrowers. These advances are reported as servicing advances within the “Receivables and other assets” line item on the consolidated balance sheets. Although transactions in MSRs are observable in the marketplace, the valuation includes unobservable market data inputs (prepayment speeds, delinquency levels, costs to service and discount rates). Changes in the fair value of MSRs as well as servicing fee income and servicing expenses are reported on the consolidated statements of income (loss). In determining the valuation of MSRs, management uses internally developed models that are primarily based on observable market-based inputs but which also include unobservable market data inputs. For additional information on our fair value methodology, see “Part I, Item 1. Consolidated Financial Statements–Note 9. Fair Value.”
Revenue Recognition on Investments in MSRs
Mortgage servicing fee income represents revenue earned from the ownership of MSRs. The servicing fees are based on a contractual percentage of the outstanding principal balance and are recognized as revenue as the related mortgage payments are collected. Corresponding costs to service are charged to expense as incurred. Approximately $15.6 million and $18.3 million in reimbursable servicing advances were receivable at September 30, 2021 and December 31, 2020, respectively, and have been classified within “Receivables and other assets” on the consolidated balance sheets.
Servicing fee income received, and servicing expenses incurred, are reported on the consolidated statements of income (loss). The difference between the fair value of MSRs and their amortized cost basis is recorded on the consolidated statements of income (loss) as “Unrealized gain (loss) on investments in Servicing Related Assets”. Fair value is generally determined by discounting the expected future cash flows using discount rates that incorporate the market risks and liquidity premium specific to the MSRs and, therefore, may differ from their effective yields.
Revenue Recognition on Securities
Interest income from coupon payments is accrued based on the outstanding principal amount of the RMBS and their contractual terms. Premiums and discounts associated with the purchase of the RMBS are amortized or accreted into interest income over the projected lives of the securities using the effective interest method. Our policy for estimating prepayment speeds for calculating the effective yield is to evaluate historical performance, consensus prepayment speeds, and current market conditions. Adjustments are made for actual prepayment activity.
Repurchase Transactions
We finance the acquisition of our RMBS for our portfolio through repurchase transactions under master repurchase agreements. Repurchase transactions are treated as collateralized financing transactions and are carried at their contractual amounts as specified in the respective transactions. Accrued interest payable is included in “Accrued expenses and other liabilities” on the consolidated balance sheets. Securities financed through repurchase transactions remain on our consolidated balance sheet as an asset and cash received from the purchaser is recorded on our consolidated balance sheet as a liability. Interest paid in accordance with repurchase transactions is recorded in interest expense on the consolidated statements of income (loss).
Income Taxes
We elected to be taxed as a REIT under the Code commencing with our short taxable year ended December 31, 2013. We expect to continue to qualify to be treated as a REIT. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate income tax rates to the extent that it annually distributes less than 100% of its taxable income. Our taxable REIT subsidiary, CHMI Solutions, Inc. and its wholly-owned subsidiary, Aurora, are subject to U.S. federal income taxes on their taxable income.
We account for income taxes in accordance with ASC 740, Income Taxes. ASC 740 requires the recording of deferred income taxes that reflect the net tax effect of temporary differences between the carrying amounts of our assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, including operating loss carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in earnings in the period that includes the enactment date. We assess our tax positions for all open tax years and determine if we have any material unrecognized liabilities in accordance with ASC 740. We record these liabilities to the extent we deem them more-likely-than-not to be incurred. We record interest and penalties related to income taxes within the provision for income taxes in the consolidated statements of income (loss). We have not incurred any interest or penalties.
Results of Operations
Presented below is a comparison of the Company’s results of operations for the periods indicated (dollars in thousands):
Results of Operations
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2021 | | | 2020 | | | 2021 | | | 2020 | |
| Income | | | | | | | | | | | | |
| Interest income | | $ | 7,043 | | | $ | 10,001 | | | $ | 20,113 | | | $ | 40,382 | |
| Interest expense | | | 646 | | | | (18 | ) | | | 1,207 | | | | 15,698 | |
| Net interest income | | | 6,397 | | | | 10,019 | | | | 18,906 | | | | 24,684 | |
| Servicing fee income | | | 13,839 | | | | 14,365 | | | | 41,127 | | | | 51,916 | |
| Servicing costs | | | 3,080 | | | | 5,266 | | | | 10,234 | | | | 17,700 | |
| Net servicing income | | | 10,759 | | | | 9,099 | | | | 30,893 | | | | 34,216 | |
| Other income (loss) | | | | | | | | | | | | | | | | |
| Realized gain (loss) on RMBS, available-for-sale, net | | | (1,050 | ) | | | 6,722 | | | | 2,027 | | | | (12,590 | ) |
| Realized loss on investments in MSRs, net | | | - | | | | - | | | | - | | | | (11,347 | ) |
| Realized loss on derivatives, net | | | (3,023 | ) | | | (7,841 | ) | | | (17,903 | ) | | | (22,039 | ) |
| Realized gain (loss) on acquired assets, net | | | (19 | ) | | | (95 | ) | | | 15 | | | | (597 | ) |
| Unrealized gain (loss) on derivatives, net | | | (5,467 | ) | | | 3,702 | | | | (9,978 | ) | | | 51,321 | |
| Unrealized loss on investments in Servicing Related Assets | | | (7,914 | ) | | | (20,972 | ) | | | (5,951 | ) | | | (131,850 | ) |
| Total Income (Loss) | | | (317 | ) | | | 634 | | | | 18,009 | | | | (68,202 | ) |
| Expenses | | | | | | | | | | | | | | | | |
| General and administrative expense | | | 1,729 | | | | 1,503 | | | | 4,897 | | | | 5,679 | |
| Management fee to affiliate | | | 1,959 | | | | 1,989 | | | | 5,869 | | | | 5,928 | |
| Total Expenses | | | 3,688 | | | | 3,492 | | | | 10,766 | | | | 11,607 | |
| Income (Loss) Before Income Taxes | | | (4,005 | ) | | | (2,858 | ) | | | 7,243 | | | | (79,809 | ) |
| Provision for (Benefit from) corporate business taxes | | | (215 | ) | | | (2,116 | ) | | | 1,418 | | | | (17,548 | ) |
| Net Income (Loss) | | | (3,790 | ) | | | (742 | ) | | | 5,825 | | | | (62,261 | ) |
| Net (income) loss allocated to noncontrolling interests in Operating Partnership | | | 77 | | | | 10 | | | | (117 | ) | | | 1,147 | |
| Dividends on preferred stock | | | 2,462 | | | | 2,459 | | | | 7,390 | | | | 7,379 | |
| Net Loss Applicable to Common Stockholders | | $ | (6,175 | ) | | $ | (3,191 | ) | | $ | (1,682 | ) | | $ | (68,493 | ) |
Presented below is summary financial data on our segments together with the data for the Company as a whole, for the periods indicated (dollars in thousands):
Segment Summary Data
| | | Servicing Related Assets | | | RMBS | | | All Other | | | Total | |
| Income Statement | | | | | | | | | | | | |
| Three Months Ended September 30, 2021 | | | | | | | | | | | | |
| Interest income | | $ | 120 | | | $ | 6,923 | | | $ | - | | | $ | 7,043 | |
| Interest expense | | | (808 | ) | | | 1,454 | | | | - | | | | 646 | |
| Net interest income | | | 928 | | | | 5,469 | | | | - | | | | 6,397 | |
| Servicing fee income | | | 13,839 | | | | - | | | | - | | | | 13,839 | |
| Servicing costs | | | 3,080 | | | | - | | | | - | | | | 3,080 | |
| Net servicing income | | | 10,759 | | | | - | | | | - | | | | 10,759 | |
| Other expense | | | (14,210 | ) | | | (3,263 | ) | | | - | | | | (17,473 | ) |
| Other operating expenses | | | 1,030 | | | | - | | | | 2,658 | | | | 3,688 | |
| Benefit from corporate business taxes | | | (215 | ) | | | - | | | | - | | | | (215 | ) |
| Net Income (Loss) | | $ | (3,338 | ) | | $ | 2,206 | | | $ | (2,658 | ) | | $ | (3,790 | ) |
| | | | | | | | | | | | | | | | | |
| Three Months Ended September 30, 2020 | | | | | | | | | | | | | | | | |
| Interest income | | $ | 380 | | | $ | 9,621 | | | $ | - | | | $ | 10,001 | |
| Interest expense | | | (1,297 | ) | | | 1,279 | | | | - | | | | (18 | ) |
| Net interest income | | | 1,677 | | | | 8,342 | | | | - | | | | 10,019 | |
| Servicing fee income | | | 14,365 | | | | - | | | | - | | | | 14,365 | |
| Servicing costs | | | 5,266 | | | | - | | | | - | | | | 5,266 | |
| Net servicing income | | | 9,099 | | | | - | | | | - | | | | 9,099 | |
| Other income (expense) | | | (25,492 | ) | | | 7,008 | | | | - | | | | (18,484 | ) |
| Other operating expenses | | | 1,178 | | | | - | | | | 2,314 | | | | 3,492 | |
| Benefit from corporate business taxes | | | (2,116 | ) | | | - | | | | - | | | | (2,116 | ) |
| Net Income (Loss) | | $ | (13,778 | ) | | $ | 15,350 | | | $ | (2,314 | ) | | $ | (742 | ) |
| | | | | | | | | | | | | | | | | |
| Nine Months Ended September 30, 2021 | | | | | | | | | | | | | | | | |
| Interest income | | $ | 345 | | | $ | 19,768 | | | $ | - | | | $ | 20,113 | |
| Interest expense | | | (2,767 | ) | | | 3,974 | | | | - | | | | 1,207 | |
| Net interest income | | | 3,112 | | | | 15,794 | | | | - | | | | 18,906 | |
| Servicing fee income | | | 41,127 | | | | - | | | | - | | | | 41,127 | |
| Servicing costs | | | 10,234 | | | | - | | | | - | | | | 10,234 | |
| Net servicing income | | | 30,893 | | | | - | | | | - | | | | 30,893 | |
| Other income (expense) | | | (34,090 | ) | | | 2,300 | | | | - | | | | (31,790 | ) |
| Other operating expenses | | | 2,438 | | | | - | | | | 8,328 | | | | 10,766 | |
| Provision for corporate business taxes | | | 1,418 | | | | - | | | | - | | | | 1,418 | |
| Net Income (Loss) | | $ | (3,941 | ) | | $ | 18,094 | | | $ | (8,328 | ) | | $ | 5,825 | |
| | | | | | | | | | | | | | | | | |
| Nine Months Ended September 30, 2020 | | | | | | | | | | | | | | | | |
| Interest income | | $ | 2,500 | | | $ | 37,882 | | | $ | - | | | $ | 40,382 | |
| Interest expense | | | 850 | | | | 14,848 | | | | - | | | | 15,698 | |
| Net interest income | | | 1,650 | | | | 23,034 | | | | - | | | | 24,684 | |
| Servicing fee income | | | 51,916 | | | | - | | | | - | | | | 51,916 | |
| Servicing costs | | | 17,700 | | | | - | | | | - | | | | 17,700 | |
| Net servicing income | | | 34,216 | | | | - | | | | - | | | | 34,216 | |
| Other expense | | | (82,094 | ) | | | (45,008 | ) | | | - | | | | (127,102 | ) |
| Other operating expenses | | | 2,913 | | | | - | | | | 8,694 | | | | 11,607 | |
| Benefit from corporate business taxes | | | (17,548 | ) | | | - | | | | - | | | | (17,548 | ) |
| Net Loss | | $ | (31,593 | ) | | $ | (21,974 | ) | | $ | (8,694 | ) | | $ | (62,261 | ) |
| | | Servicing Related Assets | | | RMBS | | | All Other | | | Total | |
| Balance Sheet | | | | | | | | | | | | |
| September 30, 2021 | | | | | | | | | | | | |
| Investments | | $ | 210,819 | | | $ | 865,904 | | | $ | - | | | $ | 1,076,723 | |
| Other assets | | | 46,350 | | | | 28,281 | | | | 63,011 | | | | 137,642 | |
| Total assets | | | 257,169 | | | | 894,185 | | | | 63,011 | | | | 1,214,365 | |
| Debt | | | 135,000 | | | | 777,416 | | | | - | | | | 912,416 | |
| Other liabilities | | | 1,829 | | | | 5,212 | | | | 12,402 | | | | 19,443 | |
| Total liabilities | | | 136,829 | | | | 782,628 | | | | 12,402 | | | | 931,859 | |
| Book value | | $ | 120,340 | | | $ | 111,557 | | | $ | 50,609 | | | $ | 282,506 | |
| December 31, 2020 | | | | | | | | | | | | |
| Investments | | $ | 174,414 | | | $ | 1,228,251 | | | $ | - | | | $ | 1,402,665 | |
| Other assets | | | 51,063 | | | | 55,260 | | | | 84,500 | | | | 190,823 | |
| Total assets | | | 225,477 | | | | 1,283,511 | | | | 84,500 | | | | 1,593,488 | |
| Debt | | | 111,379 | | | | 1,149,978 | | | | - | | | | 1,261,357 | |
| Other liabilities | | | 2,392 | | | | 6,370 | | | | 10,803 | | | | 19,565 | |
| Total liabilities | | | 113,771 | | | | 1,156,348 | | | | 10,803 | | | | 1,280,922 | |
| Book value | | $ | 111,706 | | | $ | 127,163 | | | $ | 73,697 | | | $ | 312,566 | |
Interest Income
Interest income for the three-month period ended September 30, 2021 was $7.0 million as compared to $10.0 million for the three-month period ended September 30, 2020. This $3.0 million decrease in interest income primarily resulted from the sale of RMBS.
Interest income for the nine-month period ended September 30, 2021 was $20.1 million as compared to $40.4 million for the nine-month period ended September 30, 2020. This $20.3 million decrease in interest income primarily resulted from the sale of RMBS.
Interest Expense
Interest expense for the three-month period ended September 30, 2021 was $646,000 as compared to $(18,000) for the three-month period ended September 30, 2020. The $664,000 increase in interest expense was substantially related to an increase in interest expense being offset against net interest income on interest rate swaps.
Interest expense for the nine-month period ended September 30, 2021 was $1.2 million as compared to $15.7 million for the nine-month period ended September 30, 2020. The $14.5 million decrease in interest expense was substantially related to fewer repurchase agreement borrowings as the Company sold securities and repaid related borrowings.
Change in Fair Value of Investments in Servicing Related Assets
The fair value of our investments in Servicing Related Assets for the three-month periods ended September 30, 2021 and September 30, 2020 decreased by approximately $7.9 million and $21.0 million, respectively, primarily due to changes in valuation inputs or assumptions and paydown of underlying loans.
The fair value of our investments in Servicing Related Assets for the nine-month periods ended September 30, 2021 and September 30, 2020 decreased by approximately $6.0 million and $131.9 million, respectively, primarily due to changes in valuation inputs or assumptions and paydown of underlying loans.
Change in Fair Value of Derivatives
The fair value of derivatives for the three-month periods ended September 30, 2021 and September 30, 2020 decreased by approximately $5.5 million and increased by approximately $3.7 million, respectively, primarily due to changes in interest rates and the composition of our derivatives relative to the prior year.
The fair value of derivatives for the nine-month periods ended September 30, 2021 and September 30, 2020 decreased by approximately $10.0 million and increased by approximately $51.3 million, respectively, primarily due to changes in interest rates and the composition of our derivatives relative to the prior year.
General and Administrative Expense
General and administrative expense for the three-month period ended September 30, 2021 increased by approximately $226,000 as compared to the three-month period ended September 30, 2020. The increase was primarily due to a one-time payment in settlement of claims by a state regulator that Aurora should be licensed as a mortgage servicer in order to hold MSRs, which was partially offset by a decrease of $225,000 in legal and information technology expenses.
General and administrative expense for the nine-month period ended September 30, 2021 decreased by approximately $782,000 as compared to the nine-month period ended September 30, 2020. The decrease was primarily due to higher professional fees related to market disruptions in the first quarter of 2020 due to the COVID-19 pandemic.
Management Fees to Manager
Management fees for the three and nine-month periods ended September 30, 2021 as compared to the comparable periods ended September 30, 2020, decreased by approximately $30,000 and $59,000, respectively.
Net Income Allocated to Noncontrolling Interests in Operating Partnership
Net income allocated to noncontrolling interests in the Operating Partnership, which are LTIP-OP Units owned by directors and officers of the Company and by certain other individuals who provide services to us through the Manager, represented approximately 2.0% and 1.8% of net income for the three-month periods ended September 30, 2021 and September 30, 2020, respectively. The increase was due to the issuance of LTIP-OP Units during the nine-month period ended September 30, 2021.
Net income allocated to noncontrolling interests in the Operating Partnership, represented approximately 2.0% and 1.8% of net income for the nine-month periods ended September 30, 2021 and September 30, 2020, respectively. The increase was due to the issuance of LTIP-OP Units during the nine-month period ended September 30, 2021.
For the period indicated below, our accumulated other comprehensive income (loss) changed as a result of the indicated gains and losses (dollars in thousands):
Accumulated Other Comprehensive Income (Loss)
| | | Three MonthsEnded September 30, 2021 | |
| Accumulated other comprehensive gain (loss), June 30, 2021 | | $ | 14,241 | |
| Other comprehensive income (loss) | | | 1,562 | |
| Accumulated other comprehensive gain (loss), September 30, 2021 | | $ | 15,803 | |
| | | | | |
| | | Nine Months Ended September 30, 2021 | |
| Accumulated other comprehensive gain (loss), December 31, 2020 | | $ | 35,594 | |
| Other comprehensive income (loss) | | | (19,791 | ) |
| Accumulated other comprehensive gain (loss), September 30, 2021 | | $ | 15,803 | |
| | | Three Months Ended September 30, 2020 | |
| Accumulated other comprehensive gain (loss), June 30, 2020 | | $ | 49,569 | |
| Other comprehensive income (loss) | | | (2,110 | ) |
| Accumulated other comprehensive gain (loss), September 30, 2020 | | $ | 47,459 | |
| | | | | |
| | | Nine Months Ended September 30, 2020 | |
| Accumulated other comprehensive gain (loss), December 31, 2019 | | $ | 41,414 | |
| Other comprehensive income (loss) | | | 6,045 | |
| Accumulated other comprehensive gain (loss), September 30, 2020 | | $ | 47,459 | |
Our GAAP equity changes as the values of our RMBS are marked to market each quarter, among other factors. The primary causes of mark to market changes are changes in interest rates. During the three-month period ended September 30, 2021, the sales of securities contributed to a net unrealized gain on our RMBS of approximately $1.6 million, which is recorded in accumulated other comprehensive income (loss). During the nine-month period ended September 30, 2021, a 59 basis point increase in the 10 Year U.S. treasury rate caused a net unrealized loss on our RMBS of approximately $19.8 million, which is recorded in accumulated other comprehensive income (loss).
Non-GAAP Financial Measures
This Management’s Discussion and Analysis of Financial Condition and Results of Operations section contains analysis and discussion of a non-GAAP metric called Earnings Available for Distribution (“EAD”). Prior to this quarterly report on Form 10-Q we referred to this metric as core earnings. Although EAD and core earnings are calculated identically, we believe the revised name better reflects the purpose to which investors may use the metric in the following non-GAAP measurements:
| • | earnings available for distribution; and |
| • | earnings available for distribution per average common share. |
EAD is a non-GAAP financial measure that we currently define as GAAP net income (loss), excluding realized gain (loss) on RMBS, realized and unrealized gain (loss) on investments in MSRs (net of any estimated MSR amortization), realized and unrealized gain (loss) on derivatives and realized (gain) loss on acquired assets. MSR amortization refers to the portion of the change in fair value of the MSR that is primarily due to the realization of cashflows or runoff and includes an adjustment for any gain or loss on the capital used to purchase the MSR. EAD is adjusted to exclude outstanding LTIP-OP Units in our Operating Partnership and dividends paid on preferred stock. Additionally, EAD excludes any tax (benefit) expense on realized and unrealized gain (loss) on MSRs.
EAD are provided for purposes of potential comparability to other issuers that invest in residential mortgage-related assets. We believe providing investors with EAD, in addition to related GAAP financial measures, may provide investors some insight into our ongoing operational performance. However, the concept of EAD does have significant limitations, including the exclusion of realized and unrealized gains (losses), and given the apparent lack of a consistent methodology among issuers for defining EAD, it may not be comparable to similarly titled measures of other issuers, which define EAD differently from us and each other. As a result, EAD should not be considered a substitute for our GAAP net income (loss) or as a measure of our liquidity. While EAD is one indicia of the Company’s earnings capacity, it is not the only factor considered in setting a dividend and is not the same as REIT taxable income which is calculated in accordance with the rules of the IRS.
Earnings Available for Distribution
EAD for the three and nine-month periods ended September 30, 2021 as compared to the comparable periods ended September 30, 2020, decreased by approximately $3.9 million and $11.3 million respectively, or $0.23 and $0.68 per average common share, respectively, primarily due to a decrease in the size of the RMBS portfolio during 2020 and to a one-time payment in settlement of claims by a state regulator that Aurora should be licensed as a mortgage servicer in order to hold MSRs.
The following table reconciles the GAAP measure of net income (loss) to EAD and related per average common share amounts, for the periods indicated (dollars in thousands):
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2021 | | | 2020 | | | 2021 | | | 2020 | |
| Net Income (Loss) | | $ | (3,790 | ) | | $ | (742 | ) | | $ | 5,825 | | | $ | (62,261 | ) |
| Realized loss (gain) on RMBS, net | | | 1,050 | | | | (6,722 | ) | | | (2,027 | ) | | | 12,590 | |
| Realized loss on derivatives, net | | | 3,023 | | | | 7,841 | | | | 17,903 | | | | 22,039 | |
| Realized loss on investments in MSRs, net | | | - | | | | - | | | | - | | | | 11,347 | |
| Realized loss (gain) on acquired assets, net | | | 19 | | | | 95 | | | | (15 | ) | | | 597 | |
| Unrealized loss (gain) on derivatives, net | | | 5,467 | | | | (3,702 | ) | | | 9,978 | | | | (51,321 | ) |
| Unrealized loss (gain) on investments in MSRs, net of estimated MSR amortization | | | 417 | | | | 15,091 | | | | (15,411 | ) | | | 113,654 | |
| Tax (benefit) expense on realized and unrealized (loss) gain on MSRs | | | 655 | | | | (1,017 | ) | | | 4,045 | | | | (14,849 | ) |
| Total EAD: | | $ | 6,841 | | | $ | 10,844 | | | $ | 20,298 | | | $ | 31,796 | |
| EAD attributable to noncontrolling interests in Operating Partnership | | | (134 | ) | | | (198 | ) | | | (406 | ) | | | (586 | ) |
| Dividends on preferred stock | | | 2,462 | | | | 2,459 | | | | 7,390 | | | | 7,379 | |
| EAD Attributable to Common Stockholders | | $ | 4,245 | | | $ | 8,187 | | | $ | 12,502 | | | $ | 23,831 | |
| EAD Attributable to Common Stockholders, per Diluted Share | | $ | 0.25 | | | $ | 0.48 | | | $ | 0.73 | | | $ | 1.41 | |
| GAAP Net Loss Per Share of Common Stock, per Diluted Share | | $ | (0.36 | ) | | $ | (0.19 | ) | | $ | (0.10 | ) | | $ | (4.06 | ) |
Our Portfolio
MSRs
Aurora’s portfolio of Fannie Mae and Freddie Mac MSRs have an aggregate UPB of approximately $20.8 billion as of September 30, 2021.
The following tables set forth certain characteristics of the mortgage loans underlying those MSRs as of the dates indicated (dollars in thousands):
MSR Collateral Characteristics
As of September 30, 2021
| | | | | | Collateral Characteristics | |
| | | Current Carrying
Amount | | | Current Principal
Balance | | | WA Coupon | | | WA Servicing Fee | | | WA
Maturity (months) | | | Weighted Average Loan Age (months) | | | ARMs %(A) | |
| MSRs | | $ | 210,819 | | | $ | 20,781,421 | | | | 3.57 | % | | | 0.25 | % | | | 316 | | | | 24 | | | | 0.1 | % |
| MSR Total/Weighted Average | | $ | 210,819 | | | $ | 20,781,421 | | | | 3.57 | % | | | 0.25 | % | | | 316 | | | | 24 | | | | 0.1 | % |
As of December 31, 2020
| | | | | | Collateral Characteristics | |
| | | Current Carrying Amount | | | Current Principal Balance | | | WA Coupon | | | WA
Servicing Fee | | | WA Maturity (months) | | | Weighted Average Loan Age (months) | | | ARMs %(A) | |
| MSRs | | $ | 174,414 | | | $ | 21,641,277 | | | | 3.92 | % | | | 0.25 | % | | | 316 | | | | 25 | | | | 0.2 | % |
| MSR Total/Weighted Average | | $ | 174,414 | | | $ | 21,641,277 | | | | 3.92 | % | | | 0.25 | % | | | 316 | | | | 25 | | | | 0.2 | % |
ARMs % represents the percentage of the total principal balance of the pool that corresponds to ARMs and hybrid ARMs.
RMBS
The following tables summarize the characteristics of our RMBS portfolio and certain characteristics of the collateral underlying our RMBS as of the dates indicated (dollars in thousands):
RMBS Characteristics
As of September 30, 2021
| | | | | | | | Gross Unrealized | | | | | | | |
|
| Weighted Average | |
| Asset Type | | Original Face Value | | | Book Value | | | Gains | | | Losses | | | Carrying Value(A) | | | Number of Securities | | Rating | | Coupon | | | Yield(C) | | | Maturity (Years) | |
| RMBS | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Fannie Mae | | $ | 709,268 | | | $ | 510,769 | | | $ | 12,278 | | | $ | (881 | ) | | $ | 522,166 | | | | 70 | | (B) | | | 3.12 | % | | | 3.00 | % | | | 27 | |
| Freddie Mac | | | 422,028 | | | | 339,213 | | | | 6,557 | | | | (2,032 | ) | | | 343,738 | | | | 39 | | (B) | | | 2.99 | % | | | 2.86 | % | | | 28 | |
| Total/Weighted Average | | $ | 1,131,296 | | | $ | 849,982 | | | $ | 18,835 | | | $ | (2,913 | ) | | $ | 865,904 | | | | 109 | | | | | 3.07 | % | | | 2.94 | % | | | 28 | |
As of December 31, 2020
| | | | | | | | Gross Unrealized | | | | | | | |
| | Weighted Average | |
| Asset Type | | Original Face Value | | | Book Value | | | Gains | | | Losses | | | Carrying Value(A) | | | Number of Securities | | Rating | | Coupon | | | Yield(C) | | | Maturity (Years) | |
| RMBS | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Fannie Mae | | $ | 840,175 | | | $ | 692,665 | | | $ | 22,530 | | | $ | (39 | ) | | $ | 715,156 | | | | 81 | | (B) | | | 3.31 | % | | | 3.17 | % | | | 28 | |
| Freddie Mac | | | 549,530 | | | | 493,930 | | | | 13,106 | | | | (82 | ) | | | 506,954 | | | | 49 | | (B) | | | 2.99 | % | | | 2.87 | % | | | 28 | |
| Private Label MBS | | | 22,000 | | | | 5,944 | | | | 197 | | | | - | | | | 6,141 | | | | 5 | | (B) | | | 4.08 | % | | | 4.08 | % | | | 28 | |
| Total/Weighted Average | | $ | 1,411,705 | | | $ | 1,192,539 | | | $ | 35,833 | | | $ | (121 | ) | | $ | 1,228,251 | | | | 135 | | | | | 3.18 | % | | | 3.05 | % | | | 28 | |
| (A) | See “Part I, Item 1. Notes to Consolidated Financial Statements—Note 9. Fair Value” regarding the estimation of fair value, which approximates carrying value for all securities. |
| (B) | The Company used an implied AAA rating for the Agency RMBS. The Company’s private label RMBS were rated investment grade or better by at least one NRSRO as of December 31, 2020. |
| (C) | The weighted average yield is based on the most recent gross monthly interest income, which is then annualized and divided by the book value of settled securities. |
The following table summarizes the net interest spread of our RMBS portfolio as of the dates indicated:
Net Interest Spread
| | | September 30, 2021 | | | December 31, 2020 | |
| Weighted Average Asset Yield | | | 2.98 | % | | | 2.49 | % |
| Weighted Average Interest Expense | | | 0.72 | % | | | 0.71 | % |
| Net Interest Spread | | | 2.26 | % | | | 1.78 | % |
Liquidity and Capital Resources
Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments and other general business needs. Additionally, to maintain our status as a REIT under the Code, we must distribute annually at least 90% of our REIT taxable income. In 2017, the Internal Revenue Service issued a revenue procedure permitting “publicly offered” REITs to make elective stock dividends (i.e., dividends paid in a mixture of stock and cash), with at least 20% of the total distribution being paid in cash, to satisfy their REIT distribution requirements. On May 4, 2020, the Internal Revenue Service issued a revenue procedure that temporarily reduced (through the end of 2020) the minimum amount of the total distribution that must be paid in cash to 10%. Pursuant to these revenue procedures, the Company has in the past elected to make distributions of its taxable income in a mixture of stock and cash.
Our primary sources of funds for liquidity consist of cash provided by operating activities (primarily income from our investments in RMBS and net servicing income from our MSRs), sales or repayments of RMBS and borrowings under repurchase agreements and our MSR financing arrangements. The COVID-19 pandemic has not adversely affected our ability to access these traditional sources of our funds on the same or reasonably similar terms as available before the pandemic.
In the future, sources of funds for liquidity may include additional MSR financing, warehouse agreements, securitizations and the issuance of equity or debt securities, when feasible. During the three and nine-month periods ended September 30, 2021, the Company issued and sold 553,000 shares of common stock under the Common Stock ATM Program. The shares were sold at a weighted average price of $8.97 per share for gross proceeds of approximately $5.0 million before fees of approximately $99,000. During the three and nine-month periods ended September 30, 2020, we did not sell any capital stock pursuant to the ATM programs. In the past we have used, and we anticipate that in the future we will use a significant portion of the paydowns of the RMBS to purchase MSRs. We may also sell certain RMBS and deploy the net proceeds from such sales to the extent necessary to fund the purchase price of MSRs.
Our primary uses of funds are the payment of interest, management fees, outstanding commitments, other operating expenses, investments in new or replacement assets, margin calls and the repayment of borrowings, as well as dividends. Although we continue to maintain a higher level of unrestricted cash than prior to the pandemic,. we expect to invest more of that unrestricted cash in our targeted assets if normalization of the economy continues. We may also use capital resources to repurchase additional shares of common stock under our stock repurchase program when we believe such repurchases are appropriate and/or the stock is trading at a significant discount to net asset value. We seek to maintain adequate cash reserves and other sources of available liquidity to meet any margin calls resulting from decreases in value related to a reasonably possible (in the opinion of management) change in interest rates.
As of the date of this filing, we believe we have sufficient liquid assets to satisfy all of our short-term recourse liabilities and to satisfy covenants in our financing documents. With respect to the next twelve months, we expect that our cash on hand combined with the cash flow provided by our operations will be sufficient to satisfy our anticipated liquidity needs with respect to our current investment portfolio, including related financings, potential margin calls and operating expenses. While it is inherently more difficult to forecast beyond the next twelve months, we currently expect to meet our long-term liquidity requirements through our cash on hand and, if needed, additional borrowings, proceeds received from repurchase agreements and similar financings, proceeds from equity offerings and the liquidation or refinancing of our assets.
Our operating cash flow differs from our net income due primarily to: (i) accretion of discount or premium on our RMBS, (ii) unrealized gains or losses on our Servicing Related Assets, and (iii) impairment on our securities, if any.
Repurchase Agreements
As of September 30, 2021, we had repurchase agreements with 32 counterparties and approximately $777.4 million of outstanding repurchase agreement borrowings from 14 of those counterparties, which were used to finance RMBS. As of September 30, 2021, our exposure (defined as the amount of cash and securities pledged as collateral, less the borrowing under the repurchase agreement) to any of the counterparties under the repurchase agreements did not exceed five percent of the Company’s equity. Under these agreements, which are uncommitted facilities, we sell a security to a counterparty and concurrently agree to repurchase the same security at a later date at the same price that we initially sold the security plus the interest charged. The sale price represents financing proceeds and the difference between the sale and repurchase prices represents interest on the financing. The price at which the security is sold generally represents the market value of the security less a discount or “haircut.” The weighted average haircut on our repurchase debt at September 30, 2021 was approximately 4.8%. During the term of the repurchase transaction, which can be as short as a few days, the counterparty holds the security and posts margin as collateral. The counterparty monitors and calculates what it estimates to be the value of the collateral during the term of the transaction. If this value declines by more than a de minimis threshold, the counterparty requires us to post additional collateral (or “margin”) in order to maintain the initial haircut on the collateral. This margin is typically required to be posted in the form of cash and cash equivalents. Furthermore, we are, from time to time, a party to derivative agreements or financing arrangements that may be subject to margin calls based on the value of such instruments.
Set forth below is the average aggregate balance of borrowings under the Company’s repurchase agreements for each of the periods shown and the aggregate balance as of the end of each such period (dollars in thousands):
Repurchase Agreement Average and Maximum Amounts
| Quarter Ended | | Average Monthly Amount | | | Maximum Month-End Amount | | | Quarter Ending Amount | |
| September 30, 2021 | | $ | 790,587 | | | $ | 821,540 | | | $ | 777,416 | |
| June 30, 2021 | | $ | 858,269 | | | $ | 897,047 | | | $ | 897,047 | |
| March 31, 2021 | | $ | 1,012,389 | | | $ | 1,118,231 | | | $ | 934,001 | |
| December 31, 2020 | | $ | 1,303,927 | | | $ | 1,465,037 | | | $ | 1,149,978 | |
| September 30, 2020 | | $ | 1,374,041 | | | $ | 1,419,991 | | | $ | 1,365,471 | |
| June 30, 2020 | | $ | 1,286,998 | | | $ | 1,395,317 | | | $ | 1,395,317 | |
| March 31, 2020 | | $ | 2,383,300 | | | $ | 1,565,232 | | | $ | 1,565,232 | |
| December 31, 2019 | | $ | 2,324,976 | | | $ | 2,337,638 | | | $ | 2,337,638 | |
The decrease in the Company’s borrowings under its repurchase agreements was primarily due to the sale of RMBS securities during 2020 and 2021.
These short-term borrowings were used to finance certain of our investments in RMBS. The RMBS repurchase agreements are guaranteed by the Company. The weighted average difference between the market value of the assets and the face amount of available financing for the RMBS repurchase agreements, or the haircut, was 4.8 % and 5.0% as of September 30, 2021 and December 31, 2020, respectively. The following tables provide additional information regarding borrowings under our repurchase agreements (dollars in thousands):
Repurchase Agreement Characteristics
As of September 30, 2021
| | | RMBS Market Value | | | Repurchase Agreements | | | Weighted Average Rate | |
| Less than one month | | $ | 304,204 | | | $ | 300,823 | | | | 0.11 | % |
| One to three months | | | 496,898 | | | | 476,593 | | | | 0.12 | % |
| Total/Weighted Average | | $ | 801,102 | | | $ | 777,416 | | | | 0.11 | % |
As of December 31, 2020
| | | RMBS Market Value | | | Repurchase Agreements | | | Weighted Average Rate | |
| Less than one month | | $ | 484,920 | | | $ | 482,319 | | | | 0.23 | % |
| One to three months | | | 679,496 | | | | 667,659 | | | | 0.23 | % |
| Total/Weighted Average | | $ | 1,164,416 | | | $ | 1,149,978 | | | | 0.23 | % |
The amount of collateral as of September 30, 2021 and December 31, 2020, including cash, was $816.3 million and $1,208.8 million, respectively.
The weighted average term to maturity of our borrowings under repurchase agreements as of September 30, 2021 and December 31, 2020 was 38 days and 28 days, respectively.
MSR Financing
In July 2018, the Company, Aurora and QRS V (collectively with Aurora and the Company, the “Borrowers”) entered into a $25.0 million revolving credit facility (the “MSR Revolver”) pursuant to which Aurora pledged all of its existing and future MSRs on loans owned or securitized by Freddie Mac. The term of the MSR Revolver is 364 days with the Borrowers’ option for two renewals for similar terms followed by a one-year term out feature with a 24-month amortization schedule. The MSR Revolver was upsized to $45.0 million in September 2018. The Company also has the ability to request up to an additional $5.0 million of borrowings. On April 2, 2019, Aurora and QRS V entered into an amendment that increased the maximum amount of the MSR Revolver to $100.0 million. In July 2021, the Borrowers entered into an amendment to the MSR Revolver that extended the revolving period for an additional 364 days with the option for two more renewals of 364 days each. At the end of the revolving period, the outstanding amount will be converted to a one-year term loan. Amounts borrowed bear interest at an adjustable rate equal to a spread above one-month LIBOR. At September 30, 2021 and December 31, 2020, approximately $63.0 million and $47.5 million, respectively, was outstanding under the MSR Revolver.
In September 2019, Aurora and QRS III entered into a loan and security agreement (the “Fannie Mae MSR Financing Facility”), to replace the MSR Financing Facility. Under the Fannie Mae MSR Facility, Aurora and QRS III pledged their respective rights in all existing and future MSRs for loans owned or securitized by Fannie Mae to secure borrowings outstanding from time to time. The maximum credit amount outstanding at any one time under the facility is $200 million of which $100 million is committed. Borrowings bear interest at a rate equal to a spread over one-month LIBOR subject to a floor. The term of the facility is 24 months subject to extension for an additional 12 months if the lender agrees beginning in the 20th month. The lender and Aurora have extended the term of this facility to November 1, 2021. The Company has guaranteed repayment of all indebtedness under the Fannie Mae MSR Financing Facility. At September 30, 2021 and December 31, 2020, approximately $72.0 million and $64.0 million, respectively, was outstanding under the Fannie Mae MSR Financing Facility. See Note 16 Subsequent Events for a description of the replacement facility.
Cash Flows
Operating and Investing Activities
Our operating activities provided cash of approximately $42.0 million and our investing activities provided cash of approximately $283.7 million for the nine-month period ended September 30, 2021.
Dividends
U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its REIT taxable income, without regard to the deduction for dividends paid and excluding net capital gains, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its taxable income. We intend to make regular quarterly distributions of all or substantially all of our REIT taxable income to holders of our common and preferred stock out of assets legally available for this purpose, if and to the extent authorized by our board of directors. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and debt service on our repurchase agreements and other debt payable. If our cash available for distribution is less than our REIT taxable income, we could be required to sell assets or borrow funds to make cash distributions, or, with respect to our common stock, we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities. We will make distributions only upon the authorization of our board of directors. The amount, timing and frequency of distributions will be authorized by our board of directors based upon a variety of factors, including:
| • | actual results of operations; |
| • | our level of retained cash flows; |
| • | our ability to make additional investments in our target assets; |
| • | restrictions under Maryland law; |
| • | the terms of our preferred stock; |
| • | any debt service requirements; |
| • | the annual distribution requirements under the REIT provisions of the Code; and |
| • | other factors that our board of directors may deem relevant. |
Our ability to make distributions to our stockholders will depend upon the performance of our investment portfolio, and, in turn, upon our Manager’s management of our business. Distributions will be made quarterly in cash to the extent that cash is available for distribution. We may not be able to generate sufficient cash available for distribution to pay distributions to our stockholders. In addition, our board of directors may change our distribution policy with respect to our common stock in the future. No assurance can be given that we will be able to make any other distributions to our stockholders at any time in the future or that the level of any distributions we do make to our stockholders will achieve a market yield or increase or even be maintained over time.
We make distributions based on a number of factors, including an estimate of taxable earnings. Dividends distributed and taxable income will typically differ from GAAP earnings due to items such as fair value adjustments, differences in premium amortization and discount accretion, and nondeductible general and administrative expenses. Our common dividend per share may be substantially different than our taxable earnings and GAAP earnings per share. Our GAAP loss per diluted share for the three and nine-month periods ended September 30, 2021 was $0.36 and $0.10, respectively. Our GAAP loss per diluted share for the three and nine-month periods ended September 30, 2020 was $0.19 and $4.06, respectively.
Off-balance Sheet Arrangements
As of September 30, 2021, we did not have any off-balance sheet arrangements. We did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured investment vehicles, or special purpose or variable interest entities, established to facilitate off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities or entered into any commitment or intend to provide additional funding to any such entities.
Contractual Obligations
Our contractual obligations as of September 30, 2021 and December 31, 2020 included repurchase agreements, borrowings under our MSR financing arrangements, our Management Agreement with our Manager, and our subservicing agreements. Following the sale of the Ginnie Mae MSRs to Freedom Mortgage in June 2020, Freedom Mortgage continues to subservice certain loans that had been purchased from Ginnie Mae pools due to delinquency or default. Once these loans and any related advance claims are rehabilitated or liquidated, our subservicing agreement with Freedom Mortgage will be terminated. It is not clear when that will occur.
The following table summarizes our contractual obligations for borrowed money as of the dates indicated (dollars in thousands):
Contractual Obligations Characteristics
As of September 30, 2021
| | | Less than 1 year | | | 1 to 3 years | | | 3 to 5 years | | | More than 5 years | | | Total | |
| Repurchase agreements | | | | | | | | | | | | | | | |
| Borrowings under repurchase agreements | | $ | 777,416 | | | $ | - | | | $ | - | | | $ | - | | | $ | 777,416 | |
Interest on repurchase agreement borrowings(A) | | $ | 62 | | | $ | - | | | $ | - | | | $ | - | | | $ | 62 | |
| MSR Revolver | | | | | | | | | | | | | | | | | | | | |
| Borrowings under MSR Revolver | | $ | 63,000 | | | $ | - | | | $ | - | | | $ | - | | | $ | 63,000 | |
| Interest on MSR Revolver borrowings | | $ | 2,370 | | | $ | - | | | $ | - | | | $ | - | | | $ | 2,370 | |
| Fannie Mae MSR Financing Facility | | | | | | | | | | | | | | | | | | | | |
| Borrowings under Fannie Mae MSR Financing Facility | | $ | 72,000 | | | $ | - | | | $ | - | | | $ | - | | | $ | 72,000 | |
| Interest on Fannie Mae MSR Financing Facility | | $ | 438 | | | $ | - | | | $ | - | | | $ | - | | | $ | 438 | |
As of December 31, 2020
| | | Less than 1 year | | | 1 to 3 years | | | 3 to 5 years | | | More than 5 years | | | Total | |
| Repurchase agreements | | | | | | | | | | | | | | | |
| Borrowings under repurchase agreements | | $ | 1,149,978 | | | $ | - | | | $ | - | | | $ | - | | | $ | 1,149,978 | |
Interest on repurchase agreement borrowings(A) | | $ | 492 | | | $ | - | | | $ | - | | | $ | - | | | $ | 492 | |
MSR Revolver | | | | | | | | | | | | | | | | | | | | |
| Borrowings under MSR Revolver | | $ | 47,500 | | | $ | - | | | $ | - | | | $ | - | | | $ | 47,500 | |
| Interest on MSR Revolver borrowings | | $ | 1,134 | | | $ | - | | | $ | - | | | $ | - | | | $ | 1,134 | |
| Fannie Mae MSR Financing Facility | | | | | | | | | | | | | | | | | | | | |
| Borrowings under Fannie Mae MSR Financing Facility | | $ | 64,000 | | | $ | - | | | $ | - | | | $ | - | | | $ | 64,000 | |
| Interest on Fannie Mae MSR Financing Facility | | $ | 1,655 | | | $ | - | | | $ | - | | | $ | - | | | $ | 1,655 | |
| (A) | Interest expense is calculated based on the interest rate in effect at September 30, 2021 and December 31, 2020, respectively, and includes all interest expense incurred through those dates. |
Management Agreement
The Management Agreement with our Manager provides that our Manager is entitled to receive a management fee, the reimbursement of certain expenses and, in certain circumstances, a termination fee. The management fee is an amount equal to 1.5% per annum of our stockholders’ equity, adjusted as set forth in the Management Agreement, and calculated and payable quarterly in arrears. We will also be required to pay a termination fee equal to three times the average annual management fee earned by our Manager during the two four-quarter periods ending as of the end of the most recently completed fiscal quarter prior to the effective date of the termination. Such termination fee will be payable upon termination or non-renewal of the Management Agreement by us without cause or by our Manager if we materially breach the Management Agreement.
We pay all of our direct operating expenses, except those specifically required to be borne by our Manager under the Management Agreement. Our Manager is responsible for all costs incident to the performance of its duties under the Management Agreement. We believe that our Manager uses the proceeds from its management fee in part to pay the Services Provider for services provided under the Services Agreement Our officers receive no cash compensation directly from us. Our Manager provides us with our officers. Our Manager is entitled to be reimbursed for an agreed upon portion of the costs of the wages, salary and other benefits with respect to our chief financial officer, and general counsel, originally based on the percentages of their working time and efforts spent on matters related to the Company. The amount of the wages, salary and benefits reimbursed with respect to the officers our Manager provides to us is subject to the approval of the compensation committee of our board of directors.
The term of the Management Agreement will expire on October 22, 2021 and will be automatically renewed for a one-year term on such date and on each anniversary of such date thereafter unless terminated or not renewed as described below. Either we or our Manager may elect not to renew the Management Agreement upon expiration of its initial term or any renewal term by providing written notice of non-renewal at least 180 days, but not more than 270 days, before expiration. No such written notice of non-renewal was provided in 2021 and the Management Agreement’s term was automatically extended until October 22, 2022. In the event we elect not to renew the term, we will be required to pay our Manager the termination fee described above. We may terminate the Management Agreement at any time for cause effective upon 30 days prior written notice of termination from us to our Manager, in which case no termination fee would be due. Our board of directors will review our Manager’s performance prior to the automatic renewal of the Management Agreement and, as a result of such review, upon the affirmative vote of at least two-thirds of the members of our board of directors or of the holders of a majority of our outstanding common stock, we may terminate the Management Agreement based upon unsatisfactory performance by our Manager that is materially detrimental to us or a determination by our independent directors that the management fees payable to our Manager are not fair, subject to the right of our Manager to prevent such a termination by agreeing to a reduction of the management fees payable to our Manager. Upon any termination of the Management Agreement based on unsatisfactory performance or unfair management fees, we are required to pay our Manager the termination fee described above. Our Manager may terminate the Management Agreement, without payment of the termination fee, in the event we become regulated as an investment company under the Investment Company Act. Our Manager may also terminate the Management Agreement upon 60 days’ written notice if we default in the performance of any material term of the Management Agreement and the default continues for a period of 30 days after written notice to us, whereupon we would be required to pay our Manager the termination fee described above.
Subservicing Agreements
As of September 30, 2021, Aurora had four subservicing agreements in place, one of which is with Freedom Mortgage. Following the sale of the Ginnie Mae MSRs to Freedom Mortgage in June 2020, Freedom Mortgage continues to subservice certain loans that had been purchased from Ginnie Mae pools due to delinquency or default. Once these loans and any related advance claims are rehabilitated or liquidated, the subservicing agreement with Freedom Mortgage will be terminated. It is not clear when that will occur. One of the other subservicing agreements is with RoundPoint Mortgage Servicing Corporation (“RoundPoint”). Freedom Mortgage acquired RoundPoint and it became a wholly-owned subsidiary of Freedom Mortgage in August 2020. The agreements have varying initial terms (three years, for Freedom Mortgage, and two years for the other three sub-servicers) and are subject to automatic renewal for additional terms equal to the applicable initial term unless either party chooses not to renew. Each agreement may be terminated without cause by either party by giving notice as specified in the agreement. If an agreement is not renewed by the Company or terminated by the Company without cause, de-boarding fees will be due to the subservicer. Under each agreement, the subservicer agrees to service the applicable mortgage loans in accordance with applicable law and the requirements of the applicable Agency and the Company pays customary fees to the applicable subservicer for specified services.
Joint Marketing Recapture Agreement
We attempt to reduce the exposure of our MSRs to voluntary prepayments through the structuring of recapture agreements with Aurora’s subservicers.
In May 2018, Aurora entered into a recapture purchase and sale agreement with RoundPoint, one of Aurora’s subservicers and since August 2020, a wholly-owned subsidiary of Freedom Mortgage. Pursuant to this agreement, RoundPoint attempts to refinance certain mortgage loans underlying Aurora’s MSR portfolio subserviced by RoundPoint as directed by Aurora. If a loan is refinanced, RoundPoint will sell the loan to Fannie Mae or Freddie Mac, as applicable, retain the sale proceeds and transfer the related MSR to Aurora. The agreement continues in effect while the subservicing agreement remains in effect.
Inflation
Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors affect our performance more so than inflation, although inflation rates can often have a meaningful influence over the direction of interest rates. Furthermore, our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors primarily based on our REIT taxable income, and, in each case, our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation.
| Item 3. | Quantitative and Qualitative Disclosures about Market Risk |
We seek to manage our risks related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value while, at the same time, seeking to provide an opportunity to stockholders to realize attractive risk-adjusted returns through ownership of our capital stock. While we do not seek to avoid risk completely, we believe the risk can be quantified from historical experience and seek to actively manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake.
Interest Rate Risk
Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control. We are subject to interest rate risk in connection with our assets and our related financing obligations. In general, we finance the acquisition of certain of our assets through financings in the form of repurchase agreements and bank facilities. We expect to make use of additional MSR financing, as well as possibly warehouse facilities, securitizations, re-securitizations, and public and private equity and debt issuances in addition to transaction or asset specific funding arrangements. In addition, the values of our Servicing Related Assets are highly sensitive to changes in interest rates, historically increasing when rates rise and decreasing when rates decline. Subject to maintaining our qualification as a REIT, we attempt to mitigate interest rate risk and financing pricing risk through utilization of hedging instruments, primarily interest rate swap agreements and U.S. treasury futures, respectively. We may also use financial futures, options, interest rate cap agreements, and forward sales. These instruments are intended to serve as a hedge against future interest rate or pricing changes on our borrowings.
Interest Rate Effect on Net Interest Income
Our operating results depend in large part on differences between the income earned on our assets and our cost of borrowing and hedging activities. The costs of our borrowings are generally based on prevailing market interest rates. During a period of rising interest rates, our borrowing costs generally will increase (1) while the yields earned on our leveraged fixed-rate mortgage assets will remain static and (2) at a faster pace than the yields earned on our leveraged adjustable-rate and hybrid adjustable-rate RMBS, which could result in a decline in our net interest spread and net interest margin. The severity of any such decline would depend on our asset/liability composition at the time as well as the magnitude and duration of the interest rate increase. Further, an increase in short-term interest rates could also have a negative impact on the market value of our assets, other than our Servicing Related Assets. A decrease in interest rates could have a negative impact on the market value of our Servicing Related Assets. If any of these events happen, we could experience a decrease in net income or incur a net loss during these periods, which could adversely affect our liquidity and results of operations.
Hedging techniques are partly based on assumed levels of prepayments of our assets, specifically our RMBS. If prepayments are slower or faster than assumed, the life of the investment will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions. Hedging strategies involving the use of derivatives are highly complex and may produce volatile returns.
Interest Rate Cap Risk
Any adjustable-rate RMBS that we acquire will generally be subject to interest rate caps, which potentially could cause such RMBS to acquire many of the characteristics of fixed-rate securities if interest rates were to rise above the cap levels. This issue will be magnified to the extent we acquire adjustable-rate and hybrid adjustable-rate RMBS that are not based on mortgages which are fully indexed. In addition, adjustable-rate and hybrid adjustable-rate RMBS may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in our receipt of less cash income on such assets than we would need to pay the interest cost on our related borrowings. To mitigate interest rate mismatches, we may utilize the hedging strategies discussed above under “—Interest Rate Risk.” Actual economic conditions or implementation of decisions by our Manager may produce results that differ significantly from the estimates and assumptions used in our models.
Prepayment Risk; Extension Risk
The following tables summarize the estimated change in fair value of our MSRs as of the dates indicated given several parallel shifts in the discount rate and voluntary prepayment rate (dollars in thousands):
MSR Fair Value Changes
As of September 30, 2021
| | | | (20)% |
| | | (10)% |
| | | -% |
| | | 10% |
| | | 20% |
|
| Discount Rate Shift in % | | | | | | | | | | | | | | | | | | | | |
| Estimated FV | | $ | 224,942 | | | $ | 217,667 | | | $ | 210,819 | | | $ | 204,365 | | | $ | 198,273 | |
| Change in FV | | $ | 14,123 | | | $ | 6,848 | | | $ | - | | | $ | (6,454 | ) | | $ | (12,547 | ) |
| % Change in FV | | | 7 | % | | | 3 | % | | | - | | | | (3 | )% | | | (6 | )% |
| Voluntary Prepayment Rate Shift in % | | | | | | | | | | | | | | | | | |
| Estimated FV | | $ | 238,655 | | | $ | 224,090 | | | $ | 210,819 | | | $ | 198,714 | | | $ | 187,639 | |
| Change in FV | | $ | 27,835 | | | $ | 13,270 | | | $ | - | | | $ | (12,106 | ) | | $ | (23,181 | ) |
| % Change in FV | | | 13 | % | | | 6 | % | | | - | | | | (6 | )% | | | (11 | )% |
| Servicing Cost Shift in % | | | | | | | | | | | | | | | | | | | | |
| Estimated FV | | $ | 217,347 | | | $ | 214,083 | | | $ | 210,819 | | | $ | 207,556 | | | $ | 204,292 | |
| Change in FV | | $ | 6,528 | | | $ | 3,264 | | | $ | - | | | $ | (3,264 | ) | | $ | (6,528 | ) |
| % Change in FV | | | 3 | % | | | 2 | % | | | - | | | | (2 | )% | | | (3 | )% |
As of December 31, 2020
| | | | (20)% |
| | | (10)% |
| | | -% |
| | | |
| | | 20% |
|
| Discount Rate Shift in % | | | | | | | | | | | | | | | | | | | | |
| Estimated FV | | $ | 184,906 | | | $ | 179,511 | | | $ | 174,414 | | | $ | 169,595 | | | $ | 165,031 | |
| Change in FV | | $ | 10,492 | | | $ | 5,096 | | | $ | - | | | $ | (4,820 | ) | | $ | (9,383 | ) |
| % Change in FV | | | 6 | % | | | 3 | % | | | - | | | | (3 | )% | | | (5 | )% |
| Voluntary Prepayment Rate Shift in % | | | | | | | | | | | | | | | | | |
| Estimated FV | | $ | 210,532 | | | $ | 191,603 | | | $ | 174,414 | | | $ | 158,811 | | | $ | 144,606 | |
| Change in FV | | $ | 36,117 | | | $ | 17,189 | | | $ | - | | | $ | (15,603 | ) | | $ | (29,808 | ) |
| % Change in FV | | | 21 | % | | | 10 | % | | | - | | | | (9 | )% | | | (17 | )% |
| Servicing Cost Shift in % | | | | | | | | | | | | | | | | | | | | |
| Estimated FV | | $ | 180,274 | | | $ | 177,344 | | | $ | 174,414 | | | $ | 171,485 | | | $ | 168,555 | |
| Change in FV | | $ | 5,859 | | | $ | 2,930 | | | $ | - | | | $ | (2,930 | ) | | $ | (5,859 | ) |
| % Change in FV | | | 3 | % | | | 2 | % | | | - | | | | (2 | )% | | | (3 | )% |
The following tables summarize the estimated change in fair value of our RMBS as of the dates indicated given several parallel shifts in interest rates (dollars in thousands):
RMBS Fair Value Changes
As of September 30, 2021
| | | | | | Fair Value Change | |
| | | September 30, 2021 | | | +25 Bps | | | +50 Bps | | | +75 Bps | | | +100 Bps | | | +150 Bps | |
| RMBS Portfolio | | | | | | | | | | | | | | | | | | |
| RMBS, available-for-sale, net of swaps | | $ | 1,436,545 | | | | | | | | | | | | | | | | |
| RMBS Total Return (%) | | | | | | | (0.21 | )% | | | (0.57 | )% | | | (1.06 | )% | | | (1.64 | )% | | | (3.07 | )% |
| RMBS Dollar Return | | | | | | $ | (2,998 | ) | | $ | (8,176 | ) | | $ | (15,158 | ) | | $ | (23,584 | ) | | $ | (44,127 | ) |
As of December 31, 2020
| | | | | | Fair Value Change | |
| | | December 31, 2020 | | | +25 Bps | | | +50 Bps | | | +75 Bps | | | +100 Bps | | | +150 Bps | |
| RMBS Portfolio | | | | | | | | | | | | | | | | | | |
| RMBS, available-for-sale, net of swaps | | $ | 1,570,182 | | | | | | | | | | | | | | | | |
| RMBS Total Return (%) | | | | | | | (0.07 | )% | | | (0.32 | )% | | | (0.74 | )% | | | (1.31 | )% | | | (2.81 | )% |
| RMBS Dollar Return | | | | | | $ | (1,160 | ) | | $ | (4,975 | ) | | $ | (11,554 | ) | | $ | (20,597 | ) | | $ | (44,187 | ) |
The sensitivity analysis is hypothetical and is presented solely to assist an analysis of the possible effects on the fair value under various scenarios. It is not a prediction of the amount or likelihood of a change in any particular scenario. In particular, the results are calculated by stressing a particular economic assumption independent of changes in any other assumption. In practice, changes in one factor may result in changes in another, which might counteract or amplify the sensitivities. In addition, changes in the fair value based on a 10% variation in an assumption generally may not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.
Counterparty Risk
When we engage in repurchase transactions, we generally sell securities to lenders (i.e., the repurchase agreement counterparties) and receive cash from the lenders. The lenders are obligated to resell the same securities back to us at the end of the term of the transaction. Because the cash we receive from the lender when we initially sell the securities to the lender is less than the value of those securities (this difference is the haircut), if the lender defaults on its obligation to resell the same securities back to us we would incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities). As of September 30, 2021, the Company’s exposure (defined as the amount of cash and securities pledged as collateral, less the borrowing under the repurchase agreement) to any of the counterparties under the repurchase agreements did not exceed five percent of the Company’s equity.
Our interest rate swaps and U.S. treasury futures contracts are required to be cleared on an exchange which greatly mitigates, but does not entirely eliminate, counterparty risk.
Our investments in Servicing Related Assets are dependent on the applicable mortgage sub-servicer to perform its sub-servicing obligations. If our sub-servicer fails to perform its obligations and is terminated by one or more Agencies as an approved servicer, the value of the MSRs being subserviced by that sub-servicer may be adversely affected. In addition, when we purchase MSRs from third parties, we rely, to a certain extent, on the ability and willingness of the sellers to perform their contractual obligations to remedy breaches of representations and warranties or to repurchase the affected loan and indemnify us for any losses.
Funding Risk
To the extent available on desirable terms, we expect to continue to finance our RMBS with repurchase agreement financing. We also anticipate continuing to finance our MSRs with bank loans secured by a pledge of those MSRs. Over time, as market conditions change, in addition to these financings, we may use other forms of leverage. Weakness in the financial markets, the residential mortgage markets and the economy generally could adversely affect one or more of our potential lenders and could cause one or more of our potential lenders to be unwilling or unable to provide us with financing or to increase the costs of that financing.
Liquidity Risk
Our Servicing Related Assets, as well as some of the assets that may in the future comprise our portfolio, are not publicly traded. A portion of these assets may be subject to legal and other restrictions on resale or will otherwise be less liquid than publicly traded securities. The illiquidity of these assets may make it difficult for us to sell such assets if the need or desire arises, including in response to changes in economic and other conditions.
Credit Risk
Although we expect relatively low credit risk with respect to our portfolio of Agency RMBS, our investments in MSRs and any CMOs we may acquire expose us to the credit risk of borrowers.
| Item 4. | Controls and Procedures |
Disclosure Controls and Procedures. The Company’s President and Chief Executive Officer and the Company’s Chief Financial Officer have evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d -15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information is recorded, processed, summarized and reported accurately and on a timely basis. Based on such evaluation, the Company’s President and Chief Executive Officer and the Company’s Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective.
Changes in Internal Control Over Financial Reporting. There have been no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
From time to time, the Company may be involved in various claims and legal actions in the ordinary course of business. As of September 30, 2021, the Company is not aware of any material legal or regulatory claims or proceedings.
None.
| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
None.
| Item 3. | Defaults Upon Senior Securities |
None.
| Item 4. | Mine Safety Disclosures |
Not Applicable.
Not Applicable.
Exhibit Number | | Description |
| 31.1* | | Certification of Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934. |
| | | |
| 31.2* | | Certification of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934. |
| | | |
| 32.1** | | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 32.2** | | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 101.INS* | | Inline XBRL Instance Document |
| | | |
| 101.SCH* | | Inline XBRL Taxonomy Extension Schema |
| | | |
| 101.CAL* | | Inline XBRL Taxonomy Extension Calculation Linkbase |
| | | |
| 101.DEF* | | Inline XBRL Taxonomy Definition Linkbase |
| | | |
| 101.LAB* | | Inline XBRL Taxonomy Extension Label Linkbase |
| | | |
| 101.PRE* | | Inline XBRL Taxonomy Extension Presentation Linkbase |
| | | |
| 104* | | Cover Page Interactive Data File - cover page XBRL tags are embedded within the Inline XBRL document |
*Filed herewith.
**Furnished herewith.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | CHERRY HILL MORTGAGE INVESTMENT CORPORATION |
| | | |
| November 9, 2021 | By: | /s/ Jeffrey Lown II |
| | Jeffrey Lown II |
| | President and Chief Executive Officer (Principal Executive Officer) |
| | | |
| November 9, 2021 | By: | /s/ Michael Hutchby |
| | Michael Hutchby |
| | Chief Financial Officer, Treasurer and Secretary (Principal Financial Officer) |
CHERRY HILL MORTGAGE INVESTMENT CORPORATION
FORM 10-Q
September 30, 2021
INDEX OF EXHIBITS
Exhibit Number | | Description |
| | Certification of Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934. |
| | | |
| | Certification of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934. |
| | | |
| | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | | |
| | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 101.INS* | | Inline XBRL Instance Document |
| | | |
| 101.SCH* | | Inline XBRL Taxonomy Extension Schema |
| | | |
| 101.CAL* | | Inline XBRL Taxonomy Extension Calculation Linkbase |
| | | |
| 101.DEF* | | Inline XBRL Taxonomy Definition Linkbase |
| | | |
| 101.LAB* | | Inline XBRL Taxonomy Extension Label Linkbase |
| | | |
| 101.PRE* | | Inline XBRL Taxonomy Extension Presentation Linkbase |
| | | |
| 104* | | Cover Page Interactive Data File - cover page XBRL tags are embedded within the Inline XBRL document |
*Filed herewith.
**Furnished herewith.
