Ellington Credit Company (EARN) Q2 2017 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2017 Second Quarter Financial Results Conference Call. Today's call is being recorded. [Operator Instructions]. It is now my pleasure to turn the floor over to Maria Cozine, Vice President of Investor Relations. You may begin.

Thanks, Stephanie and good morning, everyone. 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 13, 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 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 that 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 second quarter earnings conference call presentation is available on our website, earnreit.com. Management's prepared remarks will track the presentation. Please turn to slide 3 to follow along. As a reminder, during this call we'll sometimes refer to Ellington Residential by its New York Stock Exchange ticker EARN or EARN for short. With that, I'll now turn the call over to Larry.

Thanks, Maria. It's our pleasure to speak with our shareholders this morning as we release our second quarter results. As always, we appreciate your taking the time to participate on the call today. The most remarkable thing about the second quarter was the continued absence of volatility. To give you an idea of just how low volatility was this past quarter on a historical basis, the VIX stepped to a 23-year low and the MOVE, Merrill Lynch's option volatility estimate touched a 4-year low. The 10-year treasury traded in about a 30 basis point range, an even tighter range than last quarter and in fact, it was the second tightest range for a quarter in the past 40 years. Yield curve continue to flatten by 22 basis points which was double the flattening of the first quarter. Limited volatility can be somewhat of a double-edged sword, while it was supportive of our earnings as the cost to rebalance our interest rate hedging portfolio was lower, the low volatility led to be underperformance of our prepayment-protective specified pools, relative to our TBA hedges. In an environment where many investors are lulled into thinking that interest rates are range bound for good, prepayment protection just doesn't respect it deserves. That's okay. The prepayment insurance is on sale now at incredibly attractive levels, we're happy to buy it. We believe, that many investors don't appreciate, even though volatility is low, the bull flattening yield curve we've seen in the second quarter, may actually be signaling an increased probability of lower mortgage rates in the future. Meanwhile, current low levels of volatility are making dynamic duration hedging much less costly and this is reflected in the option-adjusted spread levels for Agency RMBS which remain one of the few fixed income asset classes trading at the wider end of their trailing 2 year range. So even though net interest margins have been compressed by the compression in yields in Agency RMBS, this has been more than offset by the reduction in hedging costs. Undoubtedly, some of the cheapness in Agency RMBS is also due to investor concerns about additional interest rate hikes and the Federal Reserves plans for tapering reinvestments. Despite the range-bound market, we stuck to our knitting in the second quarter, actively trading the portfolio to upgrade our holdings, while still generating strong adjusted core earnings of $0.47 per share which more than covers our roughly 11% dividend yield. After all mark-to-market adjustments, the portfolio generated gross P&L of $0.28 per share. We maintained our $0.40 dividend and our adjusted net interest margin, though a bit lower is still a very healthy 1.63%. During the 4 years that have passed since our initial public offering in May of 2013, EARN's steady performance has shown that we're patient stewards of shareholders' capital. In the second quarter, we completed our first follow-on equity offering, successfully raising about $45 million in fresh capital. Shareholders gained a major boost to liquidity after the issuance as we increased our tradable float by over 50%. More importantly, with our now much broader equity base, the issuance is already accretive to earnings. And is reducing on annualized expense ratio about -- by about 40 basis points which equates to an annual savings of about $0.07 per share. Although the offering was dilutive to book value by a modest $0.37 per share, over the long term the accretive effect on earnings will more than compensate for the modest dilution. Our May equity offering, was also very well-timed relative to the annual June rebalancing of the Russell 3000 Index. Our increased float in market capitalization allowed EARN's inclusion into the Russel 3000 Index on the June 23 rebalancing date which propelled EARN's stock price to a 2-year high. Our inclusion in the Russell 3000 Index should increase demand for our shares and represents an important source of technical support. After having accomplished all of these very important objectives with our follow-on offering, towards the end of the quarter we established an aftermarket program for our common stock. We intend to use this highly cost-effective program opportunistic to raise capital in smaller increments when the market conditions are favorable. We'll follow the same format on the call today as we have in the past. 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 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.

Thank you, Larry and good morning, everyone. In the second quarter, we had net income of $1.6 million or $0.15 per share. The main components of our net income were core earnings of $4.8 million or $0.45 per share. Net realized and unrealized gains from our securities portfolio of $3.8 million or $0.35 per share and net realized and unrealized losses from our derivative, of $7 million or $0.65 per share. By this measure, net realized and unrealized gains from our derivatives excludes the net periodic cost associated with our interest rate swaps, since they are included as a component of our core earnings. Our core earnings includes impacts of catch-up premium amortization which in the second quarter, decreased our core earnings by approximately to $275,000 or $0.02 per share. After backing out the catch-up premium amortization from interest income in both the second and first quarters of 2017, we arrived at our adjusted core earnings of $0.47 per share and $0.53 per share, respectively. As Larry mentioned, we completed a follow-on equity offering during the quarter, whereby we issued 3.23 million shares and we raised capital of approximately $45 million net of offering cost and underwriting discounts. As a result, of the offering, quarter-over quarter, our weighted average shares outstanding increased by 18% to 10.7 million shares and our ending shares outstanding increased to 12.4 million. While as of the end of the quarter, we had fully deployed the proceeds from the offering. Those proceeds were invested over the course of the second half of the quarter and we estimate that the related drag for the quarter on our net income core earnings and adjusted core earnings, was roughly $0.02 per share. The other primary factors driving in that decrease in our quarter-over quarter adjusted core earnings per share were lower net interest income which is our interest income less interest expense per share and slightly higher periodic net payment expense per share on our interest rate swap. In the second quarter, our net interest income was $7.1 million or $0.66 per share, as compared to $6.6 million or $0.72 per share in the first quarter. Our average portfolio holdings increased 13% quarter-over quarter, mainly as a result of the deployment of the proceeds from our follow-on offering and led to an increase in our interest income, however, the quarter-over quarter increase in the cost of repo increased our interest expense. Quarter-over quarter, our portfolio yield net of average repo cost decreased to 192 basis points, from 205 basis points. This decline was made up of a 2 basis point increase in the average yield on our portfolio, offset by 15 basis point increase in our cost of our repo as LIBOR increased. In managing our repo role, during the second quarter, we shortened our average repo maturity from 51 days to 39 days, to time their maturities so as to avoid a quarter end squeeze should one occur in September. So we anticipate by next quarter end, our average repo maturity will be back in line with that of previous quarters. As I mentioned earlier, we also had a slight increase in the total dollar cost of our interest rate swaps for the quarter and this was, in part caused by our decision to replace some of our TBA hedges with interest rate swap hedges in the second quarter. Based on the components of adjusted core earnings, our overall adjusted net interest margin increased 13 basis points to 1.63%. We had higher quarter-over quarter expenses of approximately $165,000 which would have been an increase of around $0.02 per share with our higher share count for the latter part of the quarter, on a per share basis, our expenses were actually lower by $0.01 per share. Our quarter-over quarter expense ratio was relatively constant at 3.6%. But given our larger capital base as a result of our follow-on offering, we expect our going forward annualized expense ratio to be about 3.2%. I should note, that this projection excludes the additional impact of any capital raised under our ATM program which would cause this ratio to decline even further. During the first quarter, we actively traded our portfolio to capitalize on sector rotation opportunities and our turnover for the quarter was 50%. Net realized and unrealized gains on our Agency RMBS were offset by losses from our interest rate swap TBAs and other hedging instruments. Lower, longer term interest rates and firm dollar rolls led to losses on our hedges, our TBA short positions which we use as a principal component of our interest rate hedging strategy, generated modest losses as low prepayment activity led to the outperformance of TBAs relative to specified pools. We ended the quarter with a leverage ratio adjusted for unsettled purchases and sales of 8.5:1 slightly higher than the 8.2:1 as of the end of March. Given that the overwhelming majority of our offering proceeds were invested in Agency RMBS, our overall leverage picked up slightly. Our book value per share was $14.71 as of the end of the quarter and included the 2.4% diluted impact of our follow-on offering. Backing out that diluted impact our economic return for the quarter was positive 0.8%. I'd like to now turn the presentation over to Mark.

Thank you, Lisa. In many ways, the second quarter felt like a continuation of the first quarter. Rates did not move a lot, mortgage spreads did not move a lot and credit spreads ground tighter. Strengthening the relative value argument for Agency MBS. Despite the constant bombardment of geopolitical headlines, the 10-year swap rate only moved in a 30 basis point range to rate volatility was low, just like Q1. We did have some volatility in the shape of the curve which flattened in response to a lackluster inflation data and the Federal Reserve's continued gradual march towards policy normalization. The overall lack of price movement pushed various measures of implied volatility to their lowest measures on record. With mortgage spreads relatively wide and delta hedging costs continuing to be low, as Lisa mentioned, we generated a positive economic return if you add back in the dilution from our capital raise. We also overcame the temporary drag on our net income created by the increase in cash in our balance sheet from the capital raise. We worked quickly, but purposefully, to deploy the new capital. By the end of the quarter, as you'll see in the portfolio slide, the proceeds of the raise were completely invested and the portfolio had reached its full size to generate earnings. During the quarter, the Fed provided a lot of clarity on the pace with which they will decrease the size of their MBS and treasury portfolio. While the start date is uncertain, but likely in Q4, the pace of the unwind was finally quantified. The agency portfolio will start to passively shrink at a rate of $4 billion a month, increasing to a maximum rate $20 billion a month after a year. The two aspects of the schedule are more mortgage friendly than what was expected. Firstly, the pace was a little slower. At this pace, it will take the Fed over seven years to get out of their holdings. Secondly, the Fed is allowing their treasury holdings to run off simultaneously with their mortgage holdings. And both portfolios are shrinking in roughly the same proportions as the size of their respective markets. So there won't be a material additional supply of mortgages relative to treasuries. That is critically important for how Agency MBS are likely to perform relative to swaps and treasuries. Especially for market participants like us, we've swapped some treasuries to hedge against overall interest rate movement. Another event this quarter, about which the market had been worried, but turned out to be uneventful, was the Fed rate hike in June. Cumulatively since December, there've been 3 Fed hikes. LIBOR's up about 80 basis points and nonetheless, our business net interest margin and ability to cover dividends are still strong. Before the Fed started hiking, there was a lot of concern about how mortgage REITs would fare in the hiking cycle. Well the cycle has started and none of the REIT operating metrics look all that different. The higher rates that mortgage REITs are paying on repo is mitigated by the higher LIBOR's that they are receiving on the fixed payer swap that they used to hedge their repo cost. As it was in the first quarter, the low volatility environment continues to be a positive in multiple ways for EARN. It keeps hedge rebalancing cost low and allows more of our NIM to flow to the bottom line. It also continues to keep MBS in somewhat of a sweet spot in terms of prepayment. We pointed this out on last quarter's call and continue to believe that investors states little changes in prepayment rates, market rallies 25 basis points or sells off. Given the lackluster performance of Agency MBS this quarter, despite the clarity given about and the attenuated nature of the Feds taper schedule, we think that it makes sense to opportunistically add to our mortgage exposure. Much of what mortgage investors worried about year ago now seems less concerning. We're comfortable taking incrementally more mortgage exposure in the current environment but we will be quick to react to changing of the guard if rates break out of their recent well-defined range. Another positive for mortgage this year and the relative underperformance this year to other spread products within fixed income. Look at Slide 5, we used this slide last quarter and we continue to point out, that Agency mortgages are one of the very few products within fixed income, that is trading near the wides of the previous two years levels. Most of the sectors are trading near the tight. This is the market pricing and the tapering of bond buying from the Federal Reserve that we believe is set to take place this year. The tapering schedule is fairly benign. We can look at the market in a few ways, to come up with this conclusion. First, it will take the Fed 7 years to liquidate their portfolio even if they were to bring the portfolio down to zero. Looking at it another way, the Agency MBS market is $6 trillion, so each year the fed will be putting -- will be looking to private investors to absorb an additional 4% to the market which is about the same order of magnitude as the amount of interest payment that MBS holders received. Mortgages are already ride -- wide relative to other asset classes. Recent policy discussions and accounting changes have increased the possibility that domestic banks will be able to add leverage, a likely positive for Agency MBS. We continue to think that a major widening as a result of the Fed tapering is unlikely and if does occur, it will probably represent an attractive short-lived opportunity to add MBS at higher NIMs. But while it seems that the fed has done a very good job of preparing the markets in the next quarter, we live in a world where foreign central banks also have a large influence on the domestic rate complex. The ECB has still mined EUR 60 billion sovereign debt a month and the BOJ is currently still committed to its rate peg. It is said that the best input to any interest rate model is humility. We saw late in the quarter how German 10-year yield's roughy doubled in a week in response to comments made by Mario Draghi. The oversees development are one of the many areas we continue to monitor for signs of a shifting tide in the low volatility low rate world. We continue to mitigate meaningful portion of our negative convexity to TBA shorts. This portfolio positioning which we generally refer to as long specified pools in short TBAs marginally underperformed this quarter. Dollar rolls continue to trade reasonably well and the benign prepayment environment referred to earlier encourage participants to move away from the call protection afforded by specified pools and into TBA. Both of these factors weighed on specified pool performance. That said, we still find pockets of alpha that we continue to trade around. In the Ginnie Mae market, for instance, we continue to find successful prepayment story, in part due to recent policy change. Slide 6 shows how the prepayment ramp in that sector has recently changed and these speeds are very fast, often getting over 50 CPR. To all the prepayment landscape on overall level remain seemingly tame, there are pockets of rapid change. The change in the Ginnie Mae market is a direct result of policy. That technology and staffing continue to provide a backdrop of faster speeds over time. Slide 7 shows how despite the backup in rates and relatively muted refinancing rates, employment in industry is still around post-crisis high. Let's look at how the portfolio evolved this quarter. It grew as we invested the proceeds of the raise. On slide 10, you can see that we have deployed the additional capital. The portfolio increased in size by about $400 million. The proceeds were primarily invested in 15 and 30-year fixed rate MBS. In those sectors, we've the -- healthy net interest margin. We did not add an Agency ARMs or reverse mortgages, so those sectors dropped as a percentage but not on an absolute basis. Our prepayments were well contained in the quarter. Looking how interest rate hedging evolved in the quarter, we decreased our TBA short to 40%, as you can see on slide 15 and added to our short duration swap portfolio. As we head into the third quarter, we find ourselves in the world where central banks across the globe seem to be talking more and more about normalization. This is occurring while most measures of volatility are near all-time lows. What we continue to keep in mind is the concern that the more manipulated a market becomes and the less private investor participation that's involved, the less the market has the ability to function as a predictor of risk. Whether it be the forward interest rate, volatility or credit risk. These type of market seem the most poised for large shocks when the stability mechanism is removed, whether in the current setting or one like the fourth quarter of last year when a large shock to the system took place. We were able to deliver positive economic returns. Our focus on prepayment stability allows us to capture NIM in a wide array of interest rate settings and our discipline hedging practices help preserve book value during times of volatility. The first half of the year has been relatively calm. We believe that we're positioned to continue to deliver gains, if that stability remains, but are also ready to change course if the market quickly takes a more volatile turn. Now back to Larry.

Thanks, Mark. As Mark just mentioned, as we move further into the second half of 2017, the low volatility trends of the first and second quarter's could start to evaporate. It's hard to imagine their volatility will decline further from here. Mixed signals are all around us. Additional Fed rate hikes, are on the table in the near future, provided the economy holds course. Tax reform will probably be the next focus for Washington. And if it does happen, there will undoubtedly be winners and losers. No less than Alan Greenspan the other day, even predicted the return of stagflation. It can be daunting for an investor who try to take any course of action with all these crosscurrents. But at Ellington Residential, we structure our portfolio differently. We're nimble and ready to adapt, as our hedging strategy sets us apart from our mortgage REIT peers. With our heavy use of TBA short positions, with our hedging interest rates so thoroughly all along the yield curve. Our strategy is designed to inflate us from big swings in interest rates and to protect us from dramatic spread widening. We model and manage prepayment risk, drawing on 20-plus years of models and experience, to identify specified pools with the most attractively priced prepayment characteristics. In the coming quarters, as the Agency RMBS market start to feel effects of Fed tapering, we expect our specified pool portfolio to do very well. The Fed's constant buying of TBAs, has essentially provided a steady stream of demand for those cheapest to deliver pools in the Agency RMBS universe. As the Fed is relatively indifferent to what kinds of bulls that actually gets delivered when it buys TBAs. As this Fed support, gradually diminishes, we believe that payoffs for specified pools over TBAs will benefit. As investors who are more discriminating of the Fed, take up the slack. Since TBA short positions represent a significant component of our hedging portfolio, any rise in pay-ups will flow right through to our bottom line. We're positioned this way not because we're making a bet on interest rates or Fed policy, but because we believe that this strategy preserves book value in the widest range of market environments, throughout market cycles. Whether or not we see fed tapering start next month or next year, we're focused on being ready to adapt to changing market conditions. Please don't forget, that during the fourth quarter of last year, when long term interest rates had one of their largest movements in 20 years, we outperformed the peer group, the only positive economic return in the Agency mortgage REIT sector. Looking forward to the rest of this year, as Mark mentioned, there are many forces, including coming from central banks outside the U.S., that could cause a reversal of this low level of volatility we've been experiencing recently. And unique to the mortgage market, GSE policy shifts always remain a very real and active force to be reckoned with. As illustrated by Mark's description of slide 6, of some recent developments of the Ginnie Mae market. Our main objective as a company is to deliver value to shareholders in the form of a stable book value, healthy dividend yield and a steady earnings stream. Whether it's hedging along the curve to protect us from interest rate risk or reducing our expense ratio through a successful completion of a secondary offering, we feel we have taken steps to deliver this value. Our stockholders have benefited from EARN's 20-plus percent total return year-to-date as well as the increased float created by the secondary offering and the added demand for shares created by our inclusion into the Russell 3000. We think that opportunities in this sector remains strong for those who can properly assess prepayment risk. And we believe that we're best-in-class when it comes to asset selection. We're always ready to actively rotate the portfolio when trading opportunities emerge, including to dial-up and down our mortgage basis exposure as we see prudent. We like to think of ourselves as an all weather REIT, able to thrive in a diversity of market environments. With that, our prepared remarks are concluded. I'll now turn the call back to the operator for questions. Operator?

[Operator Instructions]. Our first question comes from the line of Doug Harter with Crédit Suisse.

This is actually Josh on for Doug. Looking at the quarters leverage level, you guys ticked up a little bit, I'm curious is that a good run rate going forward? And if we don't see an increase in volatility, you think that level can tick up in the coming quarters?

Yes. So first of all, in terms of the increase in our leverage I think if you consider the fact our leverage went up by 0.3 right, if you adjust for unsettled purchase from sales. So if you think about the fact that our increased equity base was all deployed in our Agency strategy, with let's say an 8-ish leverage, as opposed to, there was little bit of our portfolio before that was in the non-Agency strategy and still is. And that had zero leverage on it. I think, if you adjust for that, you see that our leverage didn't increase other than the fact that more -- little bit more of our strategy now is Agency as opposed to non-Agency. So I just wanted to make that point. And then Mark, you want to handle the other part?

Sure. About the run rate?

Yes or just how are you seeing about leverage going forward? Would -- if you see volatility stay where it is, would you guys be willing to increase leverage or are you comfortable at these levels?

I guess our view was that, getting clarity on the specifics of how the Fed was going to taper, that was very important. That was a big piece of uncertainty that was hanging over the market and if they had chosen to taper in a much more aggressive way, it probably would've caused mortgages to underperform treasuries and spots, right. So I think, when they start tapering, to me it's less important than clarity on the pace of which they're going to taper. So getting that clarity, I could see us increasing leverage slightly in response to that if -- especially when they actually start to taper, if it seems that the incremental sort of passive supply they're putting in the market is well subscribed if we expect to be.

I think we have some room to increase leverage, if we want to, given the way that we managed the portfolio with the amount of TBAs, with our duration as well. So I think they could increase a little bit. But we've been pretty steady, in terms of our use of leverage if you look at it strategy-by-strategy. So -- but we definitely given where repo hair cuts aren't given sort of how risk controlled we think that our strategy is from a book value perspective, I think, we're -- we could have some room.

Yes, I also think that, with the TBA hedge -- a little bit more leverage with the TBA hedge is sort of the same kind of risk parity as a little bit less leverage and less TBA hedge. So I don't think about the leverage just as an absolute number. I think about what that leverage number in conjunction with what portion of our interest rate risk is hedged with mortgages early.

[Operator Instructions]. At this time there are no additional questions in queue. This concludes today's conference call. You may now disconnect.