Ellington Credit Company (EARN) Q4 2014 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by and welcome to the Ellington Residential Mortgage REIT Fourth Quarter 2014 Financial Results Conference Call. Today’s call is being recorded. At this time, all participants have been placed in listen-only mode and the floor will be open for your questions following the presentation. [Operator Instructions] It is now my pleasure to turn the floor over to Jason Frank, Secretary. You may begin.

Before we start, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature. As described under item 1A of our annual report on Form 10-K filed on March 21, 2014, forward-looking statements are subject to a variety of risks and uncertainties that could cause the company’s actual results to differ from its beliefs, expectations, estimates, and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events. Statements made during this conference call are made as of the date of this call and the company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. I have with me today on the call Larry Penn, Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer. With that, I will now turn the call over to Larry.

Thanks, Jason. It’s our pleasure to speak with our shareholders this morning as we release our fourth quarter results. As always we appreciate, you’re taking the time to participate on the call today. First an overview, our interest rate hedges cost us in the fourth quarter, and we lost $1.2 million or $0.13 per share on a fully mark-to-market basis. However, we maintained our core earnings at $0.76 per share, again comfortably covering our $0.55 dividend, which equates to a 12% dividend yield based on our December 31 book value and a dividend yield of more than 13% based on a February 13 closing price. As you know, we tried to avoid directional debts on interest rates, and we hedge our interest rate exposure primarily using our combination of fixed payer interest rate swaps and TBAs. Not only did the interest rates drop quite a bit in the fourth quarter, but realized volatility in the current coupon agency pass-through markets spiked almost 50% in the fourth quarter, as compared to the third quarter. What helped a lot in this volatile environment to have a hedging portfolio and included a mixture of TBAs and fixed payer swaps as opposed to fixed payer swaps alone. Our fixed payer swap hedges did weigh heavily on our performance during the quarter. In our agency portfolio, we maintained our focus on 30-year specify pools, which we believe offer substantial prepayment protection. And as usual we actively traded our agency portfolio to further enhance the composition and capitalize lies on inefficiencies. Our specified pools performed reasonably well in the fourth quarter, we’d expect them to perform better relative to our TBA hedges. Meanwhile, our non-agency portfolio contributed positively to our results, benefiting from support of fundamentals such as improving delinquency and foreclosure trends. Looking forward as you’ll hear from Mark, we’ve already seen some interesting developments in the New Year, including a meaningful increase in mortgage refinancings, which is significantly enhancing the value of our specified pools relative to TBAs. We’ll follow the same format as we have on previous calls. First, Lisa will run through our financial results. Then, Mark will discuss how the residential mortgage-backed securities market performed over the course of the quarter, how we positioned our RMBS portfolio and what our market outlook is. Finally, I will follow with some additional remarks before opening the floor to questions. As described in our earnings press release, we have posted our fourth quarter earnings conference call presentation to our website, www.earnreit.com. You can find it in three different places on the website; on the homepage, on the For Our Shareholders Page, or on the Presentations page. Lisa and Mark’s prepared remarks will track the presentation, so it would be helpful if you have this presentation in front of you and turn to Slide 4 to follow along. As a reminder, during this call, we’ll sometimes refer to Ellington Residential via New York Stock Exchange ticker, E-A-R-N or EARN for short. Hopefully, you now have the presentation in front of you and open to Page 4. And with that, I’m going to turn it over to Lisa.

Thank you, Larry, and good morning, everyone. Though, our core earnings, was stable quarter-over-quarter, in the fourth quarter, our hedges generated losses as interest rates declined. In the fourth quarter, we had a net loss of $1.2 million or $0.13 per share. The break down sound was as follows: Our core earnings was approximately $7 million or $0.76 per share. We had net realized and unrealized gains from our mortgage-backed securities portfolio of $14.1 million or $1.54 per share. And we had net realized and unrealized losses from our derivative of $22.2 million or $2.43 per share, excluding that portion which is related to the net periodic cost associated with our interest rate swaps. Our derivative, our principally our interest rate hedges and our primarily comprise the interest rate swaps and shorts TBA. For comparison in the third quarter, we had net income of $3.5 million or $0.39 per share. Our net income for the third quarter was composed of core earnings of $6.9 million or $0.76 per share, net realized and unrealized losses on mortgage-backed securities up $3.4 million or $0.37 per share and net realized and unrealized losses on our interest rate hedging derivatives of $42,000 or less than $0.01 per share. Our net interest margin increased 11 basis points in the fourth quarter to 2.49%, excuse me, this was driven by a 3 basis points increase in our average portfolio yield and an 8 basis points decline in our cost to fund for the quarter. Our portfolio yield benefited from increased cash flows on our non-Agency RMBS and to a lesser extent a cash of premium amortization adjustment related to our Agency RMBS. Our interest rate swap hedging costs were positively impacted by the decline in interest rates, as well as the fact that the weighted average remaining term of our interest rates swaps declined by about six months to 8.6 years. Additionally we shifted our interest rate hedges a little bit during the fourth quarter and increased the weight of our TBA short position. On our income statements, gains and losses from these TBA hedges are included in net realized losses on financial derivatives and change in net realized gains and losses on financial derivatives and they do not impact core earnings. During the quarter, we also generated positive income from our loan TBA positions. This income is also not included in our core earnings and is amended to approximately $1.7 million or $0.19 per share. We ended the fourth quarter with a portfolio of assets totaling $1.393 billion, up slightly from the third quarter to enhance our portfolio and generate trading gains we turned over approximately 20% of our agency portfolio during the fourth quarter, as measured by sales, and excluding principal paydowns. Our outstanding borrowings grew to $1.323 billion in the fourth quarter, up from $1.233 billion at the end of the third quarter, resulting in an increase in our leverage ratio to 8.1:1 up from 7.3:1. However, if we adjust each period for unsettled security purchases and sales, our leverage ratios were 7.9:1 and 7.5:1 as of December 31 and September 30 respectively. We have declared to pay dividends totaling $2.20 per share for this 2014 year. Based on our estimates, our capital income for 2014 ran somewhat ahead of our dividends. With that I’ll turn the presentation over to Mark.

Thanks Lisa. During the fourth quarter the biggest story in the bond market was a big drop in yield and the long end of the treasury curve. Our TBA margins performed well, specified pool pricing didn’t reflect the increased in prepayment risk associated with the decline in the long-term interest rates. This left specified pools which offer investors prepayment protection to under-perform their swap hedges. Despite a 35 basis point decline in 30-year mortgage rates, pay-up values barely moved in the fourth quarter. Within our agency portfolio our average pay-up increased only 11 basis points in the quarter. Our weighted average coupon actually increased slightly, and we increased a percentage of loan balance paper in that portfolio. The underperformance of prepayment protection values hurt our performance during the quarter that is often the case in bond market underperformance in one quarter can be reversed by out performance in the following quarter. Since the end of the year, the refinancing indexes increased materially, revealing the risk to premium MBS, that don’t offer protection as prepayments increase. As Refi indexes increased, pay-ups have increased materially in 2015 reversing their fourth quarter underperformance. You can see this on Slide 7, which shows the price spread between Fannie 4s, that are the most responsive and Fannie 4s are least responsive to refinancing incentive. The graph shows how the market is valuing the trade-off between a small amount of extra yield provided by jumbo loan pools, versus significant prepayment protection provided by low loan balance pools. The blue line is the differential in 30 seconds of a point or TIX [ph] between the two types of Fannie MEA’s 4% coupon bonds. The underlying borrowers had a 40 basis points incentive to refinance at the start of the fourth quarter and with rates dropping that expanded to a 90 basis point incentive to refinance by early February 2015. The jumbo pools are not TBA eligible, so they trade at lower prices than TBAs. They are also the most responsive pools to drop in interest rates. The underlying loans have an average balance of 520,000 in pristine borrower credits. So borrowers with loans in this category realize the greatest dollar savings when they refinance in the lower rate and reduce their monthly payments, and because they have the best credits, they are able to navigate the refinancing process most efficiently. Additionally, mortgage originators burdened by high fixed cost for each new loan are more likely to target higher loan balance borrowers for refinancing in order to maximize profitability. The low loan balance pools have an average balance of only 65,000, one-eighth the size of the jumbo pools. Well on prepayment risk is low investors buy jumbos to get little extra yield, because they trade at a lower price in TBAs. And in the most recent prepayment report 2014 winter jumbo pools paid at 47 CPR and low loan balance pools paid at 4 CPR. But as you can see in the Slide 7, despite the drop in mortgage rates and the associated increase in incentive to Refi during the fourth quarter, the jumbo low loan balance price bid really didn’t move much in the fourth quarter. Since quarter end as Refi index excess increase the spread difference was increased a lot. Going forward we expect a lot of volatility in pay-ups and based on current interest rate levels prepayment risk is definitely a concern. Technology is also making prepayment risk more of a factor. Take a look at Slide 8, entitled, some efficient originators prepay faster. We’ve all heard a lot about how tight mortgage credit is and how difficult and time consuming it is to get a mortgage now. In general that’s true and Fannie Mae and Freddie Mac no longer offer streamlined origination programs, comparable to what they had pre-crisis. If you look on more granular level, some of the non-bank originators have been able to lower origination cost and increase efficiencies to the point where borrowers with loans in their pools are significantly more responsive to refinance incentives, compared to the market as a whole. With these more efficient originators with low cost structures - I’m sorry - and these more efficient originators with low cost structures have been taking market share from less efficient originators. Quicken is the most dramatic example. Prepayment speeds on Quiken new production Fannie MEA’s 3.5 coupons ramped up into the 40s CPR and 50s CPR, ten times more than other originators. Quicken has been successful in increasing market share and over time they and other similar originators will make many borrowers more efficient in taking advantage of Refi opportunities. So we expect to see a kind of slow increase in prepayment response in this occur overtime as a greater percentage of new borrowers are touched by more efficient originators. And remember, TBA mortgages are a cheapest to deliver pool. If Quicken pools are materially faster than the cohort, and if the FED does known them all, they can quickly become the type of pool that gets delivered into TBA trades, therefore determining the TBA price. If you go through Refi rates this whole process gets accelerated as more borrowers are out looking for new mortgages. Another significant event in our last earnings call was the reduction in the FHA insurance premium. I’ll discuss this more in a minute, but that development definitely puts policy risk back on the table as a factor that can effect prepayments. The cumulative impact of these effects has led to faster prepayment speeds and more risk for the generic pools underlying TBAs and combined with the absence of FED buying in higher coupons, this was a resulted in sharply higher - sharply lower roll levels for many higher coupon TBAs. You can see this on Slide 9. This shows you the yield an investor gets by annualizing the most recent monthly roll on Fannie Mae’s 4.5 coupons. The FED has not settled any trades in this coupon since March 2014. Back then when the role was high, the annualized yield was about 3.5%. Now without FED’s sponsorship, with faster prepayment speeds and with the non-bank originators bring some more responsive pools into the market, the roll has declined materially. The annualized yield is down to about 1.5%. This is another effect that we really only start to see at the very end of last quarter and has been persistent into 2015, which is a notable drop in rolled levels, specified pools are much more attractive. We expect high rolls only in coupons with FED buying a lot of the production, there’s no Fannie Mea is 3% and 3.5%. These are the longer duration mortgages, so roll strategies are going to force investors into a longer duration MBS. We like long TBA roll positions from time to time and we use them, but only as of small part of our investment portfolio. They won’t allow for a range of coupon and a range of asset durations. As I just mentioned the other significant development in the mortgage market since quarter end, was the 50 basis point reduction in the FHA insurance premium. Our holdings were not directly impacted by this, as we don’t have any material holdings in Ginnie Mae, the bigger implication is that this rule in market inflection point and credit cost and credit availability. Since the credit crisis, mortgage credit has been tight and the cost of credit has gone up, for years we have seen steady GC increases from Freddie and Fannie and steady insurance premium increases from FHA. So the announcement in January marks change. This is the government trying to support the housing market by further reducing mortgage cost. It’s another prepayment risk, investor who don’t know pools or prepayment protection. We think it’s likely the Fannie and Freddie who will respond with some reduction in the cost of agency guarantee fees, especially with the improved pricing information they now have from the risk transfer deals. Moving onto how we manage our portfolio during the fourth quarter, traded actively turning over about 20% of the agency portfolio, as low loan balance pay-up prices lagged, increase in prepayment risk, we increased our holdings even though they already made up the vast majority of our agency for holding at the end of the third quarter. By the end of the fourth quarter, MHA and loan balance protected pools made up almost 90% of our agency pool holdings. We continue to allocate a small portion of our capital non-agency mortgages, where we primarily own deeply discounted jumbo and Alt-A, that portfolio gives us some diversification benefits and enhances its yield. Given that we own our non-Agency portfolio and an average dollar price is 64, our non-Agency portfolio can benefit from any loosening of the agency credit box as more non-agency borrowers are able to refinance into agency loans. Looking forward, we expect continued rate volatility. The market might have continued with the FED rate hike later this year, it might have to continue with the Greek exit from the Euro, prepayment volatility has also increased in 2015, driven not only by the drop in yields, but also by increasing policy risk and the lower cost structures and better technology platforms of some mortgage originators. Against this backdrop we like the high-quality prepayment protection in our portfolio, which protects our net interest margin and we welcome to trading opportunities that we see in times of increased volatility. With that, I’ll turn the call over to Larry.

Thanks Mark. Though we experienced a moderate loss in the fourth quarter, I’m pleased with our performance for the full year, including our solid and consistent core earnings and our economic return on book value of almost 10%. Given that we have accomplished there as well as simultaneously focusing on controlling interest rate risk, prepayment risk and government policy risk, we think these results are quite good. I’m looking back over the nearly two-year periods since our IPO. You can see that we have outperformed the agency REIT peer group as a whole since our inception. We believe that our active trading and dynamic hedging are the keys to our long-term out performance. At the pace of mortgage refinancing has accelerated in early 2015, our specified tools have appreciated in value and so far have nicely outperformed our hedges. Looking forward to the rest of 2015, our interest rate volatility and prepayment volatility each present distinct challenges, we believe it some real shocks in either category will bring numerous dislocations and thereby lots of opportunities for us. We are keeping on especially closed eye on the Agency IO market. Our pricing levels are still relatively reaching our opinion, which could come under tremendous pressure if interest rates return to the levels we saw, just late last month. We are also always keenly mindful of potential policy risk. In fact, we have consciously avoided taking positions that we feel would leave us vulnerable to foreseeable policy risks such as expansions to HARP refinancing programs and loosening agency underwriting standards. Meanwhile, we are able to be nimble given our size. We should make it easier for us to reposition the portfolio quickly to take advantage of any opportunities that may suddenly arise, including a niche sectors such as reverse mortgages or assertoric [ph] IOs. This concludes our prepared remarks and we’re now pleased to take your questions. Operator?

The floor is now open for questions. [Operator Instructions] Thank you. Our first question comes from the line of Steve DeLaney of JMP Securities.

Question, so Larry, when I look back at 2014 for EARN, I have two, the first thing that strikes me is I think the question that you put up between your core EPS of just over $3 and your dividends paid at $2.20, probably the widest in the mortgage REIT space, and I wanted to tie that into Lisa’s comments that at year-end, or I believe you said Lisa, correct me if I’m wrong that for 2014 that your actual taxable EPS did exceed the dividends paid. Did I hear you correctly there?

Yes, so…

Yes, yes.

Yes, so our taxable income runs kind of in between our core earnings and our dividends. So what I would say is when you look at our dividends, I would say its been sized really more to our taxable income, than to our core earnings and the other thing I would say is that our dividend is also size, obviously we can’t - if we have to do all the REIT tests, so…

Sure.

We need to distribute sufficient income. But we want to leave ourselves a little room because we see overtime, we’ve sized our dividend to where we sort of a longer-term run rate, so in our taxable income. So that’s what I think you should take out of this is that. And exactly how, where is it in between the core earnings and the dividends its - I’m not in a position to say that now, but it’s been sort of consistently in the middle may be even a slightly closer to our dividend that it is to our core earnings.

Got it, that’s helpful. And Larry, certainly, I think investors appreciate stability of the dividend as far as, as much as they do the level of the dividend. And Lisa could you help me understand is there as far as the difference between core and taxable, I don’t want to take this into the weeds with a lot of tax stuff, but is there other one or two items that they cause taxable to be less than core on a rolling basis?

It’s mostly Steve related to the amortization, on our bond portfolio under tax versus GAAP, that’s the primarily difference.

Is that premium amortization, or is that based on accretion?

Yes, yes it depends on our premium amortization.

Yes, so with the way that it works is that the agency is actually published the…

Tax factor.

The tax factors for their approvals.

Yes.

And what we found is, I can explain why I think this is the case, what we found is that they tend to use prepayment assumptions, long-term prepayment assumptions - that are little faster than what the accounts will have.

Got it.

So they are actually - if you will the implied yield that they are reporting to the IRS is a little lower than the yield, that the accountants have us amortize our premium math. And eventually it all to even doubt but - the - and when you sell pools, you are going to make up the difference as they realize tax standard loss, but that’s not what drives the dividend, what drives the dividend is the more ordinary REIT income and excluding the realized part of it.

That’s very helpful. I didn’t understand that you were facing a meaningful difference there between tax and GAAP on the MBS amortization. Let me just switch to one other thing. And this is kind of big picture that hedging is obviously something that you guys spend a lot of time thinking about. We’ve been seeing more of the mortgage REITs, the agency and hybrid does, shift from traditional fixed pay swaps into Eurodollar futures. And looking at your portfolio, you are clearly in the camp of saying, okay, we’re going to use short TB - we’re going to use swaps and we’re going to use short TBA as their primary hedging tools. And I’m just curious why you see the benefits of traditional swaps versus the EDFs.

Yes hi Steve, its Mark.

Hi Mark.

We like the Eurodollar futures when we are hedging risk, say two years and shorter. So as opposed to two-year swaps, there we probably have Eurodollar futures to a little bit less liquid, but the portfolio right now, it doesn’t have a lot of hybrids and doesn’t have a lot of 15-year. So most of our interest rate exposure is on parts of the curve where the Eurodollar futures really don’t match up with the duration. So it’s a two years MIM. We like euro-dollar futures, but mostly exposed right now is little bit further on the curve than that.

Got it, it’s really not a question of margin and everything else, it’s really a matter of having an affected tax versus which you own?

Yes, yes. So if we had - if ARMs cheapened up, if we owned a lot more ARMs than I'm sure we have a lot more Eurodollars.

Got it, that’s very helpful. Okay guys, well thank you for the comments.

Thanks Steve.

Thanks Steve.

Your next question comes from the life of Richard Eckert of MLV Victor and Company.

Thank you for the color on that last question. Also I wanted to ask about the leverage kicked up in the last quarter, can I expect to see that come back down and select the mid-sevens where it’s run for most of the last year?

Yes, so what I mentioned in my remarks, Rick was that if you look at the fourth quarter compared to the third quarter, adjusting for unsettled sales and purchases, the leverage ratio was 7.9 and 7.5 respectively. And that’s been sort of the range that has been in over the last couple of years actually.

We’ve got - we still owned some pools that we had sold, but the sale was awaiting settlement usually when you sell pools, you sell them at the same type of, I used to call PSA dates and I don’t know what they are called now, that the same dates that TBA settle and so you have a lot of forward sales that are pending settlement at any given month end and we don’t have any more risk on the portfolio. And of course, we have a receivable for the securities that we’ve sold forward and we’re going to use those proceeds to payoff the borrowing, but we still have that borrowing at month end. So it’s sort of artificially increases our leverage and depending upon the sale activity of a particular month versus the month before it could make our leverage move around a little bit. So I would say that we would even encourage people to breakout from the leverage because it will create a more even picture, the borrowings that are related to securities sold forward.

Okay, thank you very much.

Your next question comes from the line of Jim Young with West Family Investments.

Yes, hi. I was just wondering, if you look at 2015 and the risks that are apparent in the marketplace, how do you access the different risks that you see are potentially impacting the portfolio? Which of these risks including some of the tail risks are you hedging for and which are the risk out there in the marketplace are you willing to assume for the portfolio. Thank you.

Hi Jim, it’s Mark. So I think what we’ve seen so far in 2015 is U.S. interest rates being much more impacted by events outside the U.S. than we saw earlier in the year. So that’s a risk we are not willing to take, right. So we’d do that by trying to hedge our interest rate exposure on an aggregated basis, but also different points on the curve. You might see us from time-to-time add volatility of the hedges. The other risk, I think, we have is that, it seems like there has been a little bit of a drifting apart between market yield levels, I mean despite [ph] some of the past week the market yield levels and dots that FED putout. So potentially in June, potentially later in the year, there will be some reconciliation there. So I think you can have a lot of interest rate volatility this year. And it’s not clear what directions things will go, a lot of people were talking about U.S. tenure is so cheaper [indiscernible]. But on the other hand, you look at U.S. interest rates and potentially over FED that might raise rates in June, to argue that rates should be high. So I think that’s a risk we’re not willing to take. The risks that we want to take that we think we’ll get paid to take, we’ve also seen big changes in prepayment expectations, right. And how the market values that and we see from time-to-time the market under valuing it, from time-to-time the market over valuing it, that we want to actively reposition the portfolio if those opportunities exist. The other thing, I think you can see, you can also see to this big uncertainty, some uncertainty around the FED said might - when the FED might stop reinventing, its on principal pay down, right. So just what they’ve said to date is that they plan on - their principle, paying down, at least through the first interest rate increase, but it’s not clear how long there after that will increase. How long after that they’ll keep reinvesting. So that can introduce a lot basis - the mortgage market and that is something that you can hedge a little bit by increasing your amount of TBA hedges. But that’s a risk that we’ll want to take some of, we think that that’s a risk that volatility to be mortgage basis will present us with opportunities this year.

Yes, let me add one more thing, if you look at the percentage of IOs that we have right now in the portfolio, on our capital base may be its only 6% of our capital and IOs. And in terms of the type of risk that we would be willing to take we would be - if there is opportunity arises, we can increase just to say 30% of our capital. That would be a huge increase and what IOs are risky either, a lot riskier than buying pools. But based upon our experience in the market going back really now 30 years, and 20 years at Ellington that’s exactly the kind of risk that we think where we do have a competitive hedge in assessing that risk. And we again, should the opportunity be compelling it up, we could take that position up very significantly. And they are - I think the risk profile of a company would be higher, but at the same time I think the reward profile of the company would be higher as well.

Okay, thank you.

Thanks, Jim.

[Operator Instructions] There are no further questions at this time. Ladies and gentlemen, this does conclude Ellington Residential Mortgage REIT fourth quarter 2014 financial results conference call. Please disconnect your line at this time and have a wonderful day.