Ellington Credit Company (EARN) Q1 2017 Earnings Report, Transcript and Summary

Good morning ladies and gentlemen, thank you for standing by and welcome to the Ellington Residential Mortgage REIT's first quarter 2017 financial results conference call. Today's call is being recorded. At this time all participants have been placed on a listen-only mode, and the floor will be open for your questions following the presentation. [Operator Instructions] It is now my pleasure to hand the program over to Maria Cozine, Vice President of Investor Relations. You may begin.

Thanks and good morning. 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 1(a) of our annual report on Form 10-K filed on March 13th, 2017 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 on the call with me today Larry Penn, Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer. As described in our earnings press release, our first quarter earnings conference call presentation is available on our website, earnreit.com. Management's prepared remarks will track the presentation. Please turn to Slide 4 to follow along. As a reminder during this call, we will sometimes refer to Ellington Residential by its New York Stock Exchange ticker E-A-R-N or EARN for short. With that, I will now turn the call over to Larry?

Thanks, Maria. It's our pleasure to speak with our shareholders this morning as we release our first quarter results. As always we appreciate your taking the time to participate on the call today. Once again, Ellington Residential had a very solid quarter. Adjusted core earnings remained strong at $0.53 per share up, $0.06 from the prior quarter. We paid and maintained our $0.40 dividend. Book value per share decreased only slightly and our adjusted net interest margin for the first quarter improved to a very healthy 1.76% up from 1.6 9% in the fourth quarter. The first quarter market environment was in many ways completely different from that of the fourth quarter. If you recall, volatility surged tremendously in the fourth quarter of last year. We had just come off of third quarter that saw a near record low mortgage rates and the highest market wide level of prepayments since 2013. And then, in the fourth quarter, long term interest rates had one of their largest spikes in over 20 years. The agency mortgage market experienced an extreme whipsaw from an environment at the beginning of the quarter where our investors were worried about a refinancing wave and watching their yields and duration strength to an environment at the end of the quarter where refinancings were coming to a screeching halt and their portfolio durations at all of a sudden become longer than they had planned for. The 30-year mortgage rate increased 90 basis points over the course of the fourth quarter, leaving the majority of 30-year agency mortgages out of the money for refinancing. Contrast all that with this first quarter when interest rate volatility did a complete [about face] from the fourth quarter. The 10-year treasury traded within a mere 31 basis point range during this past quarter and its average over the quarter was a 2.44% yield exactly to the basis point where it began the quarter whereas the yield curve had steepened by 42 basis points in the fourth quarter, it flattened by 11 basis points in the first quarter. Agency RMBS widened in the first quarter as the Federal Reserve showed itself to be as committed as ever, both to continue the interest rate hikes and to the ultimate winding down of its mortgage portfolio. Many other agency mortgage REITs were absolutely crushed in that fourth quarter, especially in their book value per share but EARN posted a solid fourth quarter with $0.47 of adjusted core earnings per share and only a slight decline in book value per share. And then, in this first quarter despite the very, very different market environment, EARN again had a solid quarter with $0.53 of adjusted core earnings per share and again only a slight decline in book value per share. How were we able to have such consistent results in such two very different quarters when other agency mortgage REITs rose and fell in sync with the markets and with each other? We believe that the answer lies in all of Ellington Residential's competitive advantages and differentiating factors that we've been highlighting since our inception. Later in my closing remarks, I'll once more run through those competitive advantages and differentiating factors and then I'll briefly discuss our positive outlook for the rest of the year. We'll follow the same format on the call today as we have in the past. First, Lisa will 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 portfolio and what our market outlook is. Finally, I'll follow with closing remarks and then we'll open the floor to questions. Over to you Lisa.

Thanks, Larry and good morning everyone. In the first quarter we had net income of $2 million or $0.22 per share. The main components of our net income were core earnings of $7.4 million or 0.81 per share, net realized and unrealized losses from our securities portfolio a $5.3 million or $0.58 per share and essentially flat net realized and unrealized gains and losses from our derivative. By this measure, net realized and unrealized gains from our derivatives excludes the net periodic cost associated with our interest rates swaps if they are included as a component of quarter earnings. Our core earnings includes the impact of catch-up premium amortization, which in the first quarter increased our core earnings by $2.6 million or $0.28 per share. After backing out the catch-up premium amortization from interest income in both the first quarter of 2017 and the fourth quarter of 2016, we arrive at our adjusted core earnings of $0.53 per share and $0.47 per share respectively. The main factors driving the net increase in our quarter-over-quarter adjusted core earnings were higher interest income - the increase in our quarter-over-quarter adjusted core earnings were higher interest income partially offset by higher cost of funds and expenses. The increase in this interest income in the first quarter was due to an increase in the average book yields on our assets given a decrease in our prepayment expectations coupled with a 3% increase in our average portfolio holdings. This increase was partially offset by an increase in our weighted average cost of funds coupled with a 2.1% increase in our average outstanding borrowings. Quarter over quarter, our weighted average repo borrowing rate rose 13 basis points as LIBOR increased during the period and our total cost of funds increased 17 basis points. Based on the components of adjusted core earnings, the weighted average yield on our average - on our aggregate portfolio increased 24 basis points to 2.99% in the first quarter and our net interest margins increased 7 basis points to 1.76%. Finally, we had higher quarter over quarter expenses of approximately $140,000 for $0.02 per share. Our quarter-over-quarter expense ratio increased from 3.1% to 3.6% but this was basically just the result of the timing of certain professional fees incurred. So our first quarter expense ratio was atypically high and our fourth quarter expense ratio was atypically low. Based on our current capital base, we are forecasting our full year expense ratio at between 3.4% and 3.5%. During the first quarter we had modest net realized and unrealized losses on our agency RMBS portfolio because of slightly wider spreads. We actively traded our portfolio to capitalize on sector rotation opportunities and our turnover for the quarter was 21%. Net realized and unrealized losses on our agency RMBS was partially offset by positive income from our interest rate swaps, which benefited from higher short-term rates. Our short TBAs which we also use as a component of our interest rate hedging strategy generated modest losses as lower prepayment activity led to the outperformance of TBAs relative to specified pools. Finally we had losses on our U.S. Treasury securities and futures hedges, which were impacted by lower longer term interest rates. Treasuries and futures represent a smaller component of our interest rate hedging portfolio relative to TBAs and swaps. All in all, when we look at our interest rate hedges excluding the periodic cost associated with our interest rate swap, which is included in core earnings, their net impact was negligible during the quarter. We ended the quarter with book value for share of $15.35 and when the first quarter dividend of $0.40 per share is taken into account, our economic returns for the quarter was 1.5%. Quarter over quarter our leverage ratio adjusted for unsettled purchases and sales dropped slightly to 8.2 to 1 as compared to 8.3 to 1 as of December 31st 2016. I would now like to turn the presentation over to Mark.

Thank you, Lisa. In sharp contrast to the fourth quarter, the first quarter had limited interest rate moves. In mid-March, the bond market tested the high end of the range in interest rates with 10-year swaps at 2.6% but quickly rallied back. Since then markets have settled into a level about 50 basis points higher than our Election Day, but about 30 basis points lower than the March high. This range bound market helped first quarter performance and it's continuing to present a favorable backdrop. It isn't just reduced volatility that makes this a good earnings environment for mortgage REITs. It's also the absolute level of rates which right now are very mortgage investor friendly. Because problems for some managers in the fourth quarter was merely mortgages behaving like they typically behaved when rates break out of a range. When rates make new lows, you have to worry about prepayment risk. When rates make new highs, you have to worry about extension risk. Those kinds of gyrations can hurt book value if you have a lot of leverage, if you aren't diligent about your hedging and if you don't have the right mix of hedges. We managed this gauntlet of volatility very well in the fourth quarter and we were able to emerge into this more hospitable bull environment without a scratch. In contrast, [the body blows to other stuff]. Reaching now about 40 basis points away from having the market really focus on extension risk, we're about 40 basis points away from worrying about prepayment risk. Net interest margins wide and rates have to move a decent amount before the situation changes. With delta hedging cost currently low, a lot of spread income drops to the bottom line. We show another positive on Slide 7. Most of the mortgage market is out of the money and significantly most of the post-2014 production that chose refi responsiveness is out of the money. So barring a substantial rally, the market shouldn't have to contend with a lot of refi generated supply. A strong fundamental for mortgages is that the spreads are wide from an absolute standpoint and they are very wide relative to other fixed income sectors. Of course, spreads are wide because of the fear of the Fed's ultimate balance sheet reduction, what is important to bear in mind is that perhaps a lot of this potential spread widening is already priced in. After years of QEing from the Fed, ECB and the BoJ, many sectors of fixed income spread assets are now priced at the tightest levels we've seen in years. Look at Slide 8 this was put together by Morgan Stanley and does a nice job of illustrating the point. Agency mortgages are the only substantial fixed income asset class that is much closer to a two-year wide spread than its type. One stated goal of QE was to force bond investors to sell their treasury and agency MBS and to buy higher yielding things instead and it worked. Investors bought high yield and investment grade corporate bonds, they bought CMBS and so on. So now your agency MBS looks like good relative value and can generate a healthy NIM. Well, what's the catch? The catch is potential Fed balance sheet reduction. Fed officials went out of their way in the first quarter to dial up the messaging about this. They've given us some guidance of when it might start either fourth quarter of this year or the first quarter of next year, and they implied that it will happen with treasuries and MBS simultaneously, but they haven't said much else. Obviously, their goal is for orderly markets. Understandably in anticipation of this balance reduction, agency MBS have widened and we are now at some of the widest MBS levels in the past two years. So while we expect some MBS spread volatility when tapering starts, some underperformance is already priced into this sector. And the third further widening of MBS spreads could actually be a very good thing for us. It may result in a book value decline when it occurs although our use of TBA shorts its hedges should greatly mitigate that risk but it should also result in a higher going forward NIM with better core earnings and therefore maybe a higher dividend as well. As a manager you want to be positioned in a way that allows you to take advantage of spread widening but not soft side, so it's that you have to deleverage because of book value declines in the middle of it. EARN has taken a conservative approach. Compared to our agency peers, we have chosen the road of less duration with generally and more TBA hedges at least for now. And thanks to this approach we have a lot less levered MBS risk than our peers. As a result in times of volatility we should have better book value stability. That's our approach and it has served us well in the past. We are now seeing better opportunities to deploy capital than we had in the fourth quarter. I'll elaborate on a few more positives that we see. First, the cost of prepayment protection is cheap. Look at Slide 9. As prepayments have flowed down, the prepayments differential between specified pools and generic pools is compressed. So the cost of adding prepayment protection has come down. As we have seen compressions in prepayments being such as we're seeing now can often be temporary. Second, another positive is that mortgages have a lot more debenture life or a lot more debenture life can [get] cash flows than they used to be. Look at Slide 10. This slide compares refinanceability of MBS pre and post crisis. Mortgages used to be a lot more callable. The cumulative weight of regulation and high compliance costs have allowed MBS to hold on to a lot of their duration in recent rallies. This also has reduced the cost of prepayment protection to concurrently protect ourselves very cheaply from some of the risk that regulation based prepayment friction diminish over time. The mortgages are currently behaving more like corporate bond substitutes at a time when corporates look expensive and mortgages look attractively priced. A third positive is that turnover speeds are faster. A stronger housing market and a slightly stronger economy have indeed increased prepayment speeds on out of the money pools. That is important because it reduces extension risk and the sell-off. Finally, a fourth positive is the financing market. We have financed a below LIBOR for several months in a row, thanks money market reform. So all these factors together make us more constructive on mortgage spreads than we were six months ago and consequently we have reduced our TBA hedges somewhat close quarter end. For the first quarter, while we didn't make any large change to portfolio composition, we did see numerous relative value opportunities and we turned over more than 20% of the portfolio. We increased our 30-year conventional allocation and we decreased our position in 15 years in Ginnie Maes. We dialed up our TBAs [split] hedges slightly during the quarter but then we dialed it back down a bunch in April. As specified loan balance payoffs generally underperformed, we added slightly to those positions. Prepayments stopped by almost 20% in the quarter. Alpha opportunities continue to be plentiful in the specified pool sector. There have been a number of newer, lesser known refinancing programs designed for new and for undersurface borrowers. Some of these are taking place at the municipal level, others specific to an individual originator. We have good success in trading these around and use them as a source of bonds for our core position. We've been more conservatively positioned since the fall of 2016. In the fourth quarter of 2016, it really helped and it really enabled us to generate solidly positive economic returns. The first quarter was a good quarter for us as well even though the environment was totally different. Our view of the opportunity in mortgages changes a lot when we get near [indiscernible] because MBS, we have range bound market. When the rates drop to the low end of the range prepayments can change and that uncertainty can cause problems. When rates get to the high end of a range, then extension risk rears its ugly head in portfolios and that may cause some investors to sell their holdings. With rates back in the middle of the post-election range, we see better value in MBS now. There's still the potential for a substantial volatility from Fedspeak and Fed balance sheet reduction fears. Just because things might work out in the long run isn't enough. You still have to get through the short term dynamics of the holder of a full one third of the entire MBS universe potentially exiting the market. So there is always a complex tradeoff between risk and reward in the market, only in hindsight is portfolio positioning so obvious. In reality the market can evolve along many paths. As a manager you have to acknowledge some unpredictability and make a choice. We think the prudent choice in the current market is to take incrementally more mortgage risk. The pros outweigh the cons and the NIM is strong and the cash flows are easily hedgeable. That's all good news. This environment is supportive of core earnings and supportive of dividends. We took down our risk during the post-election fireworks and that really ended up helping preserve book value. But you can't bring the same playbook to every game. Now it seems that it will be tougher for the government to enact policy changes than what the markets had originally anticipated and yet valuations remain on the wider side. It seems that now a little more mortgage risk makes sense. With that, I'll turn the call back over to Larry.

Thanks, Mark. For many agency mortgage REITs, the fourth quarter and first quarter was a rollercoaster as they rode the fourth quarter down and then rode the first quarter up. Many still haven't recovered their fourth quarter losses. But Ellington Residential is different. We trade actively. Our portfolio turnover is high and we're flexible. This lets us not only take advantage of short-term trading opportunities but it also enables us to adapt quickly the fast changing market environments like what we saw in the fourth quarter and our style also enables us to adapt to longer term trends in the markets. All the while we are laser focused on risk management and book value preservation. Our hedging style is disciplined and dynamic. We hedge across the entire yield curve. We rebalance our hedges when we should and we are unique in the peer group and the extent to which we have used TBA as hedging positions, which has significantly reduced many portfolio risks. We're not afraid to dial our mortgage base's exposure up and down, especially when markets look shaky like they did late last year. Of course, assets selection is key as well. And here we take advantage of Ellington's 20-plus-year history in these markets, modeling and managing prepayment risk and identifying the right entry and exit points. We do all this because we're not in the business of Fed policy prognostication or interest rate prophesies. Staying out of that business helps us sleep better at night. Thanks to our hedging strategy, we're more insulated from interest rate spikes and we're more insulated from widening yield spreads. A flatter yield curve doesn't bother us. We're also more insulated from prepayment shocks. And that's a function not only of our use of TBAs to hedge but it's also a function of our asset selection or where we are always looking for the best value in prepayment protection. We think a lot about government and GSA policy risk. And again it's a primary focus of both our assets selection and our hedging strategy to avoid getting overexposed policy risks. So looking forward to the rest of the year, we think we're more than ready for whatever rate hikes seem to be coming and for whenever the Fed decides to start tapering its reinvestment program. We remain nimble and ready to make adjustments. We believe we can adapt to extreme volatility as evidenced by our peer group outperformance in the fourth quarter and cut to capture upside in good markets as well as evidenced by our solid results in the first quarter. The way I like to put it, I believe that EARN is truly in an all-weather mortgage REIT. Since our IPO in 2013, we've consistently been saying that our objective is to deliver attractive dividend yields over market cycles while mitigating risk, especially interest rate risk and all in the form of an agency focused mortgage REIT. I continue to believe that we have delivered. EARN outperformed all of the other agency mortgage REITs last year with the highest economic return in the whole sector. We are extremely pleased that our shareholders have benefited from our stocks' nearly 20% total returns since the start of the year. As Mark described, we certainly see no shortage of excellent opportunities in the current environment and we have the utmost confidence in our investment strategy and in EARN's ability to succeed in a wide variety of market scenarios without taking undue risk. And with that our prepared remarks have concluded. I will now turn the call to the operator for questions. Operator, go ahead.

[Operator Instructions] Our first question comes from Doug Carter with Credit Suisse.

You talked about removing some of the TBA hedges in April. Did you replace those with interest rate hedges? Just kind of want to better understand the risks that you're comfortable taking today.

Sure, thanks. Thanks for the question, Doug, it's Mark. So yes when we bought back TBA hedges, we replaced them with interest rate hedges either interest rate swaps, treasuries or treasury futures. So in terms of risk we're comfortable taking and risk we're not comfortable taking, so risks we're not comfortable taking is to expose the portfolio to a lot of interest rate risk. We feel like interest rate risk is prone to a sharp movement from exaggerators factors that are very difficult to predict - Central Bank activity, geopolitical events. So we don't generally expose the portfolio to interest rate risk. We will expose the portfolio to different amounts of levered agency mortgage exposure relative to swaps and treasuries, right. And by doing that we're also implicitly exposing the portfolio to different levels of volatility risk, right. So in the fourth quarter the TBA hedges really helped a lot because as interest rates were selling off and the assets we hold were extending in duration as the market was anticipating for slow prepayment speeds, the TBA portion of our hedges were also extending in duration as a result the market anticipation of slower prepayment speeds, that helped a lot. Now that we're in this range bound environments, pretty far away as I mentioned in the prepared remarks from concerns about prepayment risk or extension risk, we decided to reduce some TBA hedges. It's a little expensive. It's a less expensive mix of hedges we have on the books now. I think for all the reasons we articulated this current environment, that positioning makes sense and it should manifest itself into a little bit higher earnings.

And I guess just looking forward obviously, we don't exactly know how it plays out but if we assume that you see some additional widening once the Fed announces the reinvestment plans, is that something where you could further reduce the TBA hedges? Would that kind of be the thought process?

Oh yeah. I mean there are plenty of companies in this space. Most companies operate with no TBA hedges and they just have more volatility exposure and more levered MBS exposure. So if we got to the point where mortgages were significantly more attractive relative to swaps and treasuries than they are now, we could we could adopt that positioning and just to choose to more frequently Delta hedge the interest rate risk in the portfolio. I think for us a lot will depend on the specifics you get of how the Fed is going to taper. So there's certainly tapering scenarios they could articulate that we think mortgages would need to widen from here to compensate investors for increased supply and there is certainly tapering scenarios they could articulate but we think the current levels of spreads are sort of excessive compensation and then we might add more mortgage basis.

If you look over time, Mark, tell me if you agree with this, I would say that for Ellington Residential, we've probably never gotten above 50% TBA hedge and we probably never gotten below 20%. And I think that we also haven't had the type of basis widening that we saw in 2009, right?

Right.

And if that happens and I think we could move outside the lower end of that range. But I think that's a pretty good, granted it's a wide range, but I think that's a pretty good indication of kind of where we usually max out and where we min out. And, Mark, I don't know if you want to give - we were at 45% roughly at quarter end, we were at 40% at the end of the year. If you want to give a little more color in terms of roughly, maybe where we've been since April dialing down a bit - dialing up the exposure or down the TBA hedge.

Right. We dialed down the TBA hedge incrementally another 5% or 10%. The one thing I would add is that if you compare an agency mortgage strategy to a credit strategy, in an agency mortgage strategy, if mortgages underperform swaps and treasuries, then it's a short-term book value hit but you're getting a long-term better net interest margin that you sort of earn out that book value hit over time. In a credit strategy, if you're wrong on credit and there is an increase in credit losses greater than expectations, that's a loss that doesn't come back to you. So it's just a fundamental difference that when mortgages widen, it's a short term headwind but there's a long term benefits of that to NIM and potentially dividend.

And let me add one more thing, which is [that] I think that when you think about almost you can look at this as sort of an overlay of several different risk that we're taking. But I think that to what extent are we exposed to the mortgage basis is obviously a risk that we dial up and down. And I think they are we have conviction that can raise from extremely high convictions to you know much lower convictions. But except in exceptional circumstances, I think generally speaking our convictions on the mortgage basis are not going to be as high as our convictions on the relative value of many specified pool sectors versus TBAs and our ability to sort of capture that Alpha and I think that so you've got basically the sort of what we look at as very high conviction on specified pools versus TBA is very often. And I think that we're more comfortable taking lots and lots of that risk and in terms of the mortgage basis I think we are comfortable obviously taking that risk and dialing up and down. But we generally think of that is except in exceptional circumstances a lower conviction positioning, so trade. So that's where we think that we can generate the best returns for investors, risk-adjusted returns for investors over cycles.

Makes sense. Thank you.

[Operator Instructions] At this time we have no further question. Ladies and gentlemen, we do thank you for participating in today's conference call. You may now disconnect your lines.