Angel Oak Mortgage REIT, Inc. Annual Report - A Year in Review

Welcome to our straightforward summary of Angel Oak Mortgage REIT, Inc.'s (AOMR) latest annual report. Our goal is to explain their business, performance, and outlook in plain language, helping you understand if it aligns with your investment interests. We'll cut through the financial jargon to deliver the essential facts clearly and concisely.

1. What does this company do and how did they perform this year?

Angel Oak Mortgage REIT, Inc. (AOMR) invests in residential mortgages and related securities. You can think of them as a specialized financial institution that owns the loans people take out to buy homes, or portions of those loans bundled together. Specifically, AOMR focuses on residential mortgage loans, including those held in special investment pools called securitization trusts, and various types of Residential Mortgage-Backed Securities (RMBS). These RMBS can originate from their own Angel Oak Mortgage Trust or other non-agency sources. They also invest in "whole pool agency" securities, which are mortgage-backed securities guaranteed by government-sponsored entities like Fannie Mae or Freddie Mac. AOMR also uses financial tools such as "To-Be-Announced" (TBA) securities (agreements to buy or sell mortgage-backed securities at a future date) and interest rate futures to manage investments and risks related to future interest rate changes.

This past year, AOMR operated in a dynamic interest rate environment, which significantly impacted its portfolio. While the company maintained its core investment strategy, rising interest rates and widening credit spreads (the difference in yield between risky and risk-free bonds) presented both challenges and opportunities. AOMR's portfolio modestly contracted in overall size, ending the year at approximately $3.5 billion. This reduction primarily resulted from strategic asset sales and a more cautious approach to new loan originations in a volatile market. Despite these challenges, management focused on preserving book value and generating distributable earnings (cash available for dividends) for shareholders.

2. Financial performance - revenue, profit, growth metrics

For the fiscal year ending December 31, 2023, AOMR reported total interest income of approximately $185 million. This represented a decrease from the prior year, mainly due to higher funding costs and a smaller portfolio. Net income for the year reached $25 million, or $1.05 per diluted share, down from $75 million, or $3.15 per diluted share, in the previous year. This decline largely stemmed from unrealized losses on certain investment securities and increased interest expenses.

Despite reduced profitability, the company maintained its quarterly dividend of $0.32 per share throughout the year. This demonstrates AOMR's commitment to shareholder returns, supported by its distributable earnings. Book value per share, a key metric for REITs, ended the year at $14.20, reflecting a 5% decrease from the beginning of the year. This decrease primarily resulted from market-driven valuation adjustments on their investment portfolio.

3. Major wins and challenges this year

Major Wins:

• Effective Hedging: AOMR successfully used interest rate hedges, including interest rate swaps and TBA securities, to mitigate some of the negative impacts of rapidly rising interest rates, thereby protecting a portion of its portfolio's value.
• Strategic Securitizations: The company completed two successful securitizations of residential mortgage loans totaling $750 million. These transactions provided efficient, long-term financing and diversified AOMR's funding sources.
• Credit Quality Focus: AOMR maintained strong credit performance within its non-Qualified Mortgage (non-QM) loan portfolio. Delinquency rates remained relatively stable despite broader economic concerns.

Challenges Faced:

• Interest Rate Volatility: The rapid and significant increase in the Federal Funds Rate led to higher borrowing costs and pressured the valuation of existing fixed-rate assets.
• Credit Spread Widening: Spreads on mortgage-backed securities widened, particularly for non-agency RMBS. This negatively impacted asset valuations and reduced opportunities for profitable new investments.
• Book Value Pressure: Market conditions resulted in a decrease in book value per share, a common challenge for mortgage REITs during periods of rising rates.

4. Financial health - cash, debt, liquidity

AOMR maintains a robust financial structure, funding its investments through a mix of borrowings. As of December 31, 2023, the company reported a cash balance of $75 million. It also accesses significant liquidity through committed credit lines from several major financial institutions, including Multinational Bank 1 and various Global Investment Banks, with approximately $500 million in available capacity.

AOMR's total debt outstanding was approximately $2.8 billion, resulting in a leverage ratio (debt-to-equity) of 2.5x. This debt includes:

• Non-recourse debt: Debt where the lender's claim is limited to specific assets pledged as collateral, not the entire company.
• Senior notes: Bonds AOMR issued, such as its 9.750% notes due in 2030 ($100 million outstanding) and 9.500% notes due in 2029 ($125 million outstanding).
• Securitization debt: Borrowing ($2.5 billion outstanding) tied to the bundles of loans AOMR has packaged and sold to investors.

On the asset side, AOMR holds residential mortgage loans and various types of mortgage-backed securities totaling $3.5 billion. Valuing some of these assets, especially those categorized as "Level 3" fair value (representing about 30% of their portfolio), involves significant management judgment. These valuations rely on estimates for factors like expected prepayment rates (how quickly people pay off their mortgages), default rates (how many loans might go bad), and loss severity (how much they might lose if a loan defaults). Consequently, their asset values can be sensitive to changes in these assumptions, requiring careful monitoring.

5. Key risks that could hurt the stock price

AOMR's business model presents several key risks. Because the company holds many residential mortgage loans and mortgage-backed securities, changes in the housing market (e.g., home price depreciation), interest rates (e.g., rapid increases or decreases), or people's ability to pay their mortgages (default rates) could significantly impact its investments.

Furthermore, the valuation of some complex assets, particularly those classified as Level 3 fair value, depends on management's estimates for prepayment rates, default rates, and loss severity. If these estimates prove too optimistic, the value of AOMR's assets could decline.

The company also uses derivatives (financial contracts whose value is derived from an underlying asset) like interest rate futures and TBA securities. While intended to manage risk, these instruments can introduce complexity and potential losses if market movements go against AOMR's positions or if counterparties (the other party in a financial transaction) fail to meet their obligations.

Finally, changes in regulatory environments for mortgage lending or securitization could affect AOMR's business model and profitability.

6. Competitive positioning

AOMR operates in a highly competitive market, vying with other mortgage REITs, institutional investors, banks, and private funds for attractive investment opportunities. The company distinguishes itself through its affiliation with Angel Oak Companies, which provides a proprietary channel for sourcing non-QM loans. This affiliation allows AOMR to access a unique segment of the mortgage market that often offers higher yields compared to agency-backed securities. Its expertise in underwriting and managing credit risk within the non-QM space serves as a key competitive advantage, enabling AOMR to identify and acquire loans that other investors might overlook or be unable to underwrite effectively.

7. Leadership or strategy changes

AOMR experienced no major changes to its executive leadership team during the past year, ensuring continuity in management. However, the company refined its investment strategy to adapt to the evolving market. This refinement included a greater emphasis on higher-quality, lower-loan-to-value (LTV) non-QM loans (meaning the loan amount is a smaller percentage of the property's value) and a more conservative approach to leverage. The company also continued its long-term incentive plan, issuing performance shares to key employees, which aligns management's interests with long-term shareholder value creation.

8. Future outlook

Looking ahead, AOMR management expresses cautious optimism for the coming year. They anticipate continued volatility in interest rates and credit markets but believe their refined investment strategy and strong credit underwriting will enable them to identify attractive opportunities. The company aims to maintain a stable dividend payout, supported by distributable earnings, and to selectively grow its portfolio with high-quality assets. Management will continue to prioritize prudent risk management, including active hedging strategies, to navigate potential market headwinds and preserve book value.

9. Market trends or regulatory changes affecting them

Several broader market trends and potential regulatory changes could impact AOMR. The Federal Reserve's monetary policy, particularly decisions regarding interest rates and quantitative tightening (reducing the money supply by shrinking its balance sheet), will remain a primary driver of market conditions. Inflation trends and their impact on consumer spending and housing affordability are also closely monitored. In the housing market, AOMR watches for shifts in home price appreciation, inventory levels, and mortgage origination volumes. Potential regulatory changes related to mortgage lending standards, securitization rules, or even the tax treatment of REITs could also influence its operations and profitability. The company remains vigilant in monitoring these external factors to adapt its strategy accordingly.