Ellington Credit Company (EARN) Q2 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing-by. Welcome to the Ellington Residential Mortgage REIT 2018 Second Quarter 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 opened for your questions following the presentation. [Operator Instructions]. It is now my pleasure to turn the floor over to Jason Frank, Corporate Council and Security. Sir, you may begin.

Thanks. 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 14, 2018, 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 Chris Smernoff, 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 ticker, E-A-R-N or EARN for short. With that, I will now turn the call over to Larry.

Thanks, Jay. It's our pleasure to speak with our shareholders this morning, as we release our second quarter results. As always, we appreciate you are taking the time to participate on the call today. Our prepared marks today will follow the earnings presentation that we posted on our website last night. Please turn to slide three. The second quarter of 2018 saw the extreme equity volatility of the first quarter subside, but the yield curve flattening continued. During the first part of the quarter, interest rates continued their recent upward trend with the 10-year U.S. Treasury yield rising 37 basis points to an almost seven-year high of 3.11% on May 17th. This trend reversed over the next two weeks as investors reacted to a possible trade war and political uncertainty in Italy. And by May 29th, the 10-year treasury had rally back almost to where that started the quarter. This flight to quality was short lived however, with the 10-year treasury finishing the quarter 12 basis points higher overall. The spread between the two-year treasury yield and the 10-year treasury yield tightened another 14 basis points over the course of the quarter. The yield curve has lately been the flattest expense since 2007, when it actually inverted during the early part of that year. On slide three, you can see the persistent quarter-over-quarter flattening. Yield curve is flattened for six consecutive quarters now, five of which are shown on this page. It’s been a bear market flattening with a two year up 127 basis points over these five quarters and the 10-year up 47 basis points. Well, bear market flattening may put downward pressure on our net interest margin. We believe that our success is not so dependent on the shape of the yield curve or the absolute level of interest rates. Because of our portfolio management strategy, we trade actively, hedge along the entire yield curve and hedge using significant TBA short positions. As you can also see on slide three, the higher interest rates caused agency RMBS prices to decline again during the quarter. But EARN's book value is stable as solid net carry in our portfolio and gains on our interest rate hedges more than offset the asset price declines. Turning now to slide four. EARN net income of $0.14 per share and adjusted core earnings and $0.36 per share during the second quarter. The company bought back approximately another 1% of its total shares outstanding at prices which are quite accretive to book value per share. And I also bought EARN shares and the open market for my personal account. Our economic return for the quarter was 1.2%. And while the first half of the year was a tough one, Ellington Residential again as the highest year-to-date economic return of all the agency mortgage rates. The vast majority of our holdings continued to be an agency RMBS with a small sleeve invested opportunistically, a non-agency RMBS. Based on yesterday’s closing price of $11.17, our annualized dividend yield is 13.2%. At quarter end, we had net mortgage assets to equity ratio of 7.4, which is higher than where we’ve been over the past few years. Despite the ongoing technical drag from Fed tapering. We believe that agency RMBS offer attractive relative value today. Prepayment fundamentals are favorable and as you can see turning the slide five. Agency RMBS yield spreads remain near their two-year widest levels in contrast to many credit sectors or spreads remain near their two-year tightest levels. As a result, after having covered a significant portion of our TBA short position in March and respond to the market selloff. We continue to keep our net mortgage exposure relatively high. We'll follow the same format on the call today as we have in the past. First, our CFO, Chris Smernoff will run through our financial results, then Mark Tecotzky 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? And finally, I’ll follow with closing remarks and then we’ll open the floor up to questions. Over to you, Chris.

Thank you, Larry and good morning everyone. Please turn to slide six for a summary of EARN’s financial results. For the quarter-ended June 30, 2018, we generated core earnings of $5.1 million or $0.40 per share broken down as follows. Total net interest income of $6.4 million plus total other gains of a $131,000 that’s total expenses of $1.4 million. By comparison we generated core earnings of $4.3 million or $0.32 per share for the quarter ended March 31, 2018. Our core earnings include the impact of a catch-up premium amortization adjustment which in the second quarter increased core earnings by approximately $480,000 or $0.04 per share. Excluding the catch-up amortization adjustments, we generated adjusted core earnings of $0.36 per share and $0.34 per share in the current and prior quarters respectively. With agency RMBS prices continue to decline during the quarter we had net realized and unrealized losses on our RMBS assets of $10.2 million. These losses were partially offset by net realized and unrealized gains on our interest rate hedges of $6.8 million and EARN had net income of $1.8 million or $0.14 per share as compared to a net loss of $4 million for the quarter ended March 31, 2018. Note that net realized and unrealized gains from our interest rate hedges exclude the net periodic cost associated with our interest rate swaps since they are included as a component of core earnings. Our results this quarter were dampened somewhat by strong TBA dollar rolls and muted prepayments, which caused TBA to outperform specified pools. Overall, the agency strategy generated gross income of $3 million or $0.24 per share. Meanwhile, our non-agency RMBS portfolio continue to perform well, generating gross income of approximately $200,000 or $0.02 per share. Despite further flattening of the yield curve, our net interest margin actually increased quarter-over-quarter, which in turn drove the increase in our adjusted core earnings per share. During the current quarter, our net interest margin adjusted to exclude the impact of catch up premium amortization was 1.17% or 8 basis points higher than the prior quarter. The average yield on our portfolio also adjusted to exclude the impact of catch up premium amortization increased 13 basis points to 3.15% while our cost of funds increased 5 basis points to 1.98%. The main driver of the increase in our cost of funds was our repo borrowing rates which rose us LIBOR increase during the quarter. With agency yield spreads near their widest levels in the last two years we continue to add new pools at higher yield levels which internally be support of our net interest margin. As you can also see on slide six, our annualized operating expense ratio for the quarter decreased slightly to 3.22% from 3.26%. Lower expenses for the quarter were mostly offset by our lower average equity base. At our current equity base, we project our going forward annualized expense ratio to continue to be about 3.2%. At the end of the second quarter, we had total equity of $174.2 million or book value per share of $13.70 as compared to a $178.3 million or $13.90 per share at the end of the prior quarter. As Larry mentioned our economic return for the second quarter was 1.2% or 5% annualized. Please turn to slide seven, which is a summary of our portfolio holdings. Our overall RMBS portfolio decreased by 3.1% to $1.58 billion as of June 30, 2018 as compared to $1.631 billion as of March 31, 2018 and our debt-to-EBITDA ratio declined slightly to 8.821 as of June 30 from 8.921 as of March 31. Next turning to slide eight. You can see information regarding our effective mortgage exposure which are the aggregate market value of our RMBS Holdings including our net short TBA position. At June 30th, we had net loan exposure to RMBS of $1.285 billion which translates to a net mortgage equity ratio of 7.421. Last quarter, we had net loan exposure to RMBS of $1.387 billion and a net mortgage asset to equity ratio of 7.821. So, our net leverage just declined slightly from last quarter, but it is still meaningfully higher than a year end when our ratio was 5.7 to 1. Please turn to slide nine. During the quarter, our interest rate hedging portfolio continue to consist predominantly of interest swaps and short positions in TBA and to a lesser extent, short positions to U.S. Treasury, Securities and Futures. In our hedging portfolio, the relative proportion based on 10-year equivalent of short positions in TBA increased quarter-over-quarter relative to the other interest rate hedges. As you can see in the chart on the left, TBA has represented 25.1% of our hedging portfolio at the end of the second quarter as compared to 19.5% at end of the prior quarter, in the chart on the right. But this was still much lower than at year end, when TBA has represented over 40% of our interest hedging. For the quarter, we’ve repurchased 115,800 common shares, at an average price per share of $11.01 and total cost of $1.3 million and at an average discount to book value of 21%. These repurchases were accretive to book value by $0.03 per share. I would now like to turn the presentation over to Mark.

Thank you, Chris. Compared to Q1, the second quarter was fairly an eventful. We posted a solid economic return, largely supported by the relatively high yield of Agency MBS, compared to swaps and treasuries. A few important headwinds and tailwinds defined the Agency MBS investment landscape for the quarter, and we think these dynamics will continue to frame the opportunity set through the end of the year. On balance, we think it is a favorable environment. First the tailwinds. A big one is shown on slide 10. The financing market is very favorable, much more favorable than spending the past five years. Three-month repo rates have settled in 10 to 20 basis points below three-month LIBOR, here we show the time series. This spread is so important, because we reduce our hedging costs by the difference and it directly adds to our net interest margin. Remember, on our interest rate swaps, which are our primary hedging instrument, we’ve received three-month LIBOR on the floating leg and payout of fixed leg. Then returned right around and payout our repo borrowing expense to our lenders. Historically, we were lucky if the difference between three months, between the three months repo rate and three months LIBOR netted out to zero. Now, we’re pocketing 10 to 20 basis points. This dynamic means that for leveraged investors, mortgages are effectively 10 to 20 basis points widening spreads. There has been a lot of concerned about how the flatter yield curve effects core earnings. For earned on the portion of our portfolio that hedge was swaps, changes in the LIBOR leg we receive on our swaps, largely cancels out changes in our repo costs and that dynamic neutralizes much of the impact of a flatter yield curve. Generally speaking, the biggest impact of our flatter yield curve is running a big positive duration gap doesn’t help your core earnings much but running a big duration gap was never a risk return trade-off we like as the mechanism for driving earnings. So, while that may affect other companies a lot, it doesn’t impact nearly as much. Another consequence of flatter yield curve is dealers are doing fewer new issue CMO securitization, because with a flatter yield curve, the shorter CMO tranches typically purchased by commercial banks have as much smaller yield pickup versus shorter-term treasuries. This new issue CMO securitization use MBS as their collateral, the MBS market loses what is usually a big chunk of demand. So, while it doesn’t necessarily affect us as much directly, the flatter yield curve does factor into our assessment of a relative value of mortgages, because we know that there are other investors that find MBS less attractive in a flatter yield curve environment. Please turn to slide 11. The second big tailwind is that right now we don’t have to take as much prepayment risk, we use most of our – most of the agency pools now or close to par, as a result our core earnings are less affected by prepayment uncertainty. This gives us much more confidence in our ability to capture NIM, with lower MBS dollar prices, investing is not as model driven as it used to be, and it is less impacted by any GSC policy changes that can increase prepayment response. Tailwind number three, is that the absolute level of prepayments is very low right now. Even high coupon MBS like 5% are barely paying 20 CPR. Because of these slow prepayment speed, the cost of prepayment protection is much cheaper than it used to be. While we believe technological changes and credit box expansion will eventually make agency MBS more responsive to refinance incentive in the future, we can easily and cheaply protect ourselves in that possibility by keeping our portfolio and predominantly prepayment protected pools now. Mortgages are just behaving a lot more like corporate funds than they used to. That coupled with prices in the near par, make the NIM more robust. Now for the headwinds. First is Fed balance sheet reduction. The Fed is not replacing a portion of the MBS and its portfolio that pay off each month. In Q3, they're net reducing by $16 billion per month, that's a big number. And other MBS investors have to come up with the capital. The mechanism by which this is happening is that went alone in the Feds portfolio pays off them or refinancing the Fed get that cash, but another investor has to buy a new loan. This pace of balance sheet reduction is scheduled to hit its maximum size of $20 billion per month in Q4. And this persistent technical drag should keep MBS yield spreads wide for a while. In addition, any widening of corporate spreads has the spillover effect on mortgage spread as we saw in Q1 when wider corporate spreads put pressure on MBS. So, while MBS yield spread may seem wide by some measures, and we have increased our mortgage exposure this year. We have the ability to add a lot more mortgage exposure and we think we might get a better entry point later. The second big tailwind. I'm sorry, the second big headwind is the reduction in central bank support from markets outside of the U.S. For U.S., our own Fed has been reducing support for the U.S. bond market. First, they stopped buying than they started hiking, now they're letting their bond portfolio run off. While the ECB and the BOJ don't own in the MBS, we do think that further reduction of European bond purchases from the ECB and a higher tenure JGB target from the BOJ have the potential to push global interest rates higher. Mortgages tend to perform much better in a range bound environment. So, we think that a selloff of U.S. 10 year note to three in a quarter would likely be accompanied by mortgage underperformance. And balance we'd like the mortgage opportunity set now and I've increased our mortgage exposure this year accordingly. As we see our mortgage is performed this quarter and next and fed balance sheet reduction is as its peak, that may be an opportunity to buy more and we can easily add another couple term of exposure. We articulate this on slide 12 being dynamic and dialing up and down mortgage exposure can be an important source of returns. My Portfolio team sees our job is constantly looking to add incremental earnings while keeping a watchful eye on any factors that can drive interest a volatility. Now back to Larry.

Thanks, Mark. As we move into the second half of the year. I like how Ellington Residential is positioned. We have used the sell off an agency RMBS to cover a good portion of our TBA. As we turn over the portfolio and add assets at the current higher yields. We are recharging our net interest margin. We continue to benefit this year from the consistently wider gap between the lower rates that repay repo borrowings and the higher LIBOR rates that we receive on the floating legs of interest rate swaps. We’ve also dialed up our mortgage exposure as RMBS prices have declined. We still believe that the outlook is strong for the specified pool sector or most of our assets are concentrated. We continue to unearth new pockets of mortgage pools that we believe are undervalued and underappreciated. The Fed exclusively purchases agency pools via TBA contracts not specified pools. So, as the Fed tapering continues to ramp on schedule. The most important technical support for TBAs will continue to dwindle, making specified pools a better and better choice for most MBS investors. That said, we also see plenty of reasons for caution. There are the more modest challenges represented by a flattening yield curve and rising interest rates. But the possibility of big shocks still out there, whether from the prospects of trade wars, slowing growth in China, or political turmoil in Europe. Additionally, as quantitative easing around the globe continues to give away to quantitative tightening. The market will continue to lose an important stabilizing force. So, in light of those risks, we believe that having a highly liquid portfolio and being disciplined about hedging or as important as ever. We want to be able to stay on the offensive from a portfolio management perspective, especially in choppy periods. As volatility typically generates investment opportunities. We’re always ready to rotate the portfolio actively 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 we able to thrive in a diversity of market environment and we look forward to the challenges ahead. With that our prepared remarks or concluded. I’ll now turn the call to the operator for questions. Operator, please go ahead.

Thank you. [Operator Instructions] Our first question comes from the line of Trevor Cranston of JMP securities.

So, you guys talked a little bit about some of the tailwinds and headwinds you’re facing and obviously you’ve increased your net mortgage exposure a little bit this year. Can you talk a little bit more about how you guys are currently thinking about the balance between increasing your NIM today versus having maybe more attractive investment opportunities later this year as quantitative using is reduced? I am particularly thinking about how you’ve taken down the size of the TBA position, the short TBA position this year, which would obviously protect against incremental spread wide when you get that does occur between so increases in NIM obviously in near term?

Sure. Hi, Trevor, its Mark. I guess the way we think about it is, seeing how the market responds to set balance sheet reduction when it gets to its peaks and now we’re near the peak, now we’re at $16 billion and the market absorb that well in July, mortgages performed very well in July. So that’ll be the same case in August and September. And then October we’ll see how things respond to $20 billion. So, we’re going to get on the answer as to how aggressively new capital comes into the mortgage market to take the fed out of balance sheet in just a couple of months right, in two months we’ll be at maximum Fed reductions. So, I don’t see a big incentive to add a lot of leverage now at these spreads given that we’re going to clear up some of the certainty relatively shortly. But I do think pull backs, 5 or 10 basis points pull back are significant enough that we want to capture I mean that would enough if as long as rates aren’t at sort of a boundary point where you typically see with mortgages is when interest rates get to a level, the market hasn’t seen for a while. Mortgages tend to perform poorly. If interest rates are sort of testing the high rent of where they’ve been for a while there which you've got 3.10 or 3.15 the market gets worried about extension risk. And if you saw say rally back below 2.75, the market gets worried about call risks. So, I think if you had a widening and the mortgage and 10-year note is sort of in the range where it’s been that would enough for us absent that I think it paves the way a little bit and see how things are in Q4, early in Q4.

Got you. That makes sense. And then second question on the slide 10, the spread between the three-month LIBOR and repo. Two questions on that. One, I was wondering if you guys could share your thoughts on whether or not you think it’s likely to sort of stabilize at the current levels, it's obviously coming a lot from where it peaked I guess in April, but sort of where you guys think that will stabilize. And then the second part of the question, if you’re able to quantify how much that spread benefited earnings in the second quarter that would be helpful? Thanks.

Yeah, so I would say, I think it’s likely to stabilize somewhere in the 10 to 20 bases where few months repo costs are 10 to 20 basis points below three months LIBOR. I think it’s likely that we’ll stabilize there. and if I had to quantify it, how much of a benefit that is versus what it was like say if you go back to 2014-2015 regime when the three months repo costs were consistently 10 basis points over LIBOR right. Let’s say, the average 15 basis points below, three months LIBOR and they used to be 10 basis points above three months LIBOR, that’s the swing of 25 basis points per annum and then times the leverage…

Seven times, that’s it.

Yeah, it’s seven times. So, 175 basis points over the course of the year.

Yeah, of course some of that, but not all of that is priced into where MBS are trading, right. So, there is some section in the market, segment of the market uses leverage and that increases demand from that sector, so it’s a portion of that is priced in to mortgages, but since there is a huge segment of the market that does not use leverage certainly not all but it’s priced and so chunk of that is absolutely flowing above line.

Yeah, and the reason why I think it’s likely to persist where repo is below few months LIBOR as we've also seen material shift in the composition of our repo counterparties and the individual appetite for repo it’s more coming from the big banks now than it used to. So, I think another metric, where I think the funding is more stable.

All right. Got it. That make sense. You guys have always had or often had some treasury positions as part of your hedging. Does this new relationship between LIBOR and repo alter how you think about using treasury shorts versus swaps as a headroom strength?

Yeah, it does. If you think back to and most of the year and year and half ago when tenure swaps -- for negative 17 basis points. Of course, they were going to get much more negative. A lot of people shifted their hedges into primarily treasury based. We chose to stay with a lot of swaps space, we thought there were reasons that swaps -- right now they have. No, we definitely -- the big move in three months LIBOR relative to repo is definitely a factor for us that gives us a preference towards the swap-based hedge as opposed to treasury-based hedges. We like to diversify, but incrementally that does push more swaps.

Okay, great. Thanks for the comments.

Thanks, Trevor.

Our next question comes from the line of Doug Harter of Credit Suisse.

Hey guys this is actually Josh [ph] on for Doug. Mark, you've talked about how you are able to be dynamic with the portfolio dialing up and down. Mortgage exposure with the when the market looks attractive. What level of leverage are you guys comfortable with running the portfolio going forward? Thanks.

I think we could add two terms of leverage definitely, we only just to be shift in hedges right. It could be further reduction of TBA, further increase of swaps to treasury to treasury future.

So, it doesn't mean more repo borrowing. I'd only have to do is buyback or more now we've already done obviously a chunk of that, but if you look at slide eight, if we wanted to dial down for example, you can see we had a lot of room to dial down by increasing that dark blue, the net short TBA positions which you've already dug out quite a bit hence dialing our mortgage exposure. If we wanted to all of a sudden, we were cautious on the mortgage base let's just say that mortgages had a really good month latter part of this month. And we wanted to then sort of lock that in a little bit, we could go sale a lot of TBAs. And we've been at times around 50% hedged with TBAs as opposed to now where it's been lately more in the 20, 25-ish area. So, we have a lot of room at this point to dial down our mortgage exposure. If we wanted to, we can do that extremely quickly, I mean it's probably one of the most liquid markets and where I'll drive the TBA market, current coupon TBAs.

Great. Thanks for the comments guys.

And we have reached the allotted time for questions-and-answers today. I would now like to turn the floor back over to Larry for any additional or closing remarks.

No, I think that do it, operator. Thank you. Thanks everyone.

Thank you. Ladies and gentlemen, this does conclude today's conference call. You may now disconnect.