Ellington Credit Company (EARN) Q3 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2018 Third Quarter Financial Results Conference Call. Today’s call is being recorded. [Operator Instructions] It is now my pleasure to turn the floor over to Jason Frank, Corporate Counsel and Secretary. Sir, you may begin.

Thank you. 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. Joining me on the call today are 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 third quarter earnings conference call presentation is available on our website, www.earnreit.com. And our comments this morning will track the presentation. Also a reminder during this call, we’ll sometimes refer to Ellington Residential by its NYSE ticker E-A-R-N or EARN for short. With that, I will now turn the call over to Larry.

Thanks, Jay and good morning, everyone. As always, we appreciate your time and your interest in Ellington Residential. On our call today, I will first give an overview of the quarter, then our CFO, Chris Smernoff, will summarize our financial results and then Mark Tecotzky, our Co-Chief Investment Officer will review the performance of the residential mortgage-backed securities market during the quarter, our portfolio positioning and our market outlook. Finally I’ll provide some closing remarks and then we’ll open the floor to questions. Let’s start with Slide 3. During the third quarter, interest rates continue to rise and the short end of the yield curve rose faster than the long end for the fifth consecutive quarter. As you can see here on this slide, the spread between the two year and the 10 year ended the quarter at just 24 basis points as compared to 33 basis points at the end of the second quarter and 85 basis points a year earlier. The yield curve lately has been the flattest since 2007 when it actually inverted during the early part of the year. The flattening curve has caused net interest margins to contract across the sector. While rising interest rates continue to be a headwind for mortgages. As you can see on Slide 3, during the third quarter, the Freddie Mac 30 year mortgage rate rose 17 basis points ending the quarter at 4.72%, which was the highest 30 year mortgage rate we’ve seen in over seven years. It has continued its upward march in the fourth quarter and it’s currently at 4.83%, which is around 90 basis points higher than it was year ago. Meanwhile, the Bloomberg Barclays US MBS agency fixed rate index recorded a negative return of 12 basis points for the third quarter and a cumulative return of negative 204 basis points year-to-date through yesterday. Despite these significant challenges EARN delivered solid results during the third quarter and has now generated the best economic return among all agency mortgage rates through the first nine months of this year. Turning to Slide 4. For the third quarter of 2018 EARN had net income of $0.07 per share and adjusted core earnings of $0.32 per share. Even with agency RMBS prices declining for yet another quarter EARN generated a positive economic return for the quarter, which we believe demonstrates the effectiveness of our hedging and portfolio management to protect book value in a challenging market environment. For the quarter the Board declared a third quarter dividend of $0.37 per share, which equates to an annualized dividend yield of more than 14% based on yesterday’s closing price of $10.44 per share. Similar to last quarter, we took advantage of wider RMBS yield spreads to cover a portion of our TBA shorts. And as a result, our net mortgage assets to equity ratio increased to 7.9:1 compared to 7.4:1 last quarter. We continue to believe that agency RMBS offers attractive value today with favorable prepayment fundamentals, and as you can see turning to Slide 5, agency RMBS yield spreads are close to their widest levels of the last 24 months. Now I’ll turn the call over to our CFO, Chris Smernoff to discuss our results in greater detail.

Thank you, Larry and good morning, everyone. Please turn to Slide 6 for a summary of EARN financial results. For the quarter ended September 30, 2018, we generated core earnings of $3.7 million or $0.29 per share. This compares to core earnings of $5.1 million or $0.40 per share for the quarter ended June 30, 2018. However, most of the decline in net interest income was due to catch-up premium amortization adjustments, which were a positive adjustment to interest income in the second quarter, but a negative adjustment in the third quarter. For the third quarter our core earnings included net interest income of $4.7 million plus total other gains of $388,000 plus total expenses of $1.3 million. Excluding the catch-up premium amortization adjustment our adjusted core earnings was $4.1 million for the third quarter or $0.32 per share. This compares to adjusted core earnings of $4.6 million or $0.36 per share for the second quarter. During the quarter, rising interest rates and falling RMBS price is generated net realized and unrealized losses on our RMBS assets of approximately $11.2 million. Net realized and unrealized gains on our interest rate hedges of $8.4 million partially offset these losses. Specified pools outperformed TBAs in the quarter due to weak TBA dollar roles, which also benefited our results. EARN had net income of $946,000 or $0.07 per share as compared to net income of $1.8 million or $0.14 per share for the quarter ended June 30, 2018. Note that net realized and unrealized gains from our interest rate hedges excludes the net periodic cost associated with our interest rate swaps, since those are included as a component of core earnings. For the third quarter, our annualized operating expense ratio was 3%, down from 3.2% in the prior quarter. The decrease in our annualized operating expense ratio for the current quarter was a result of lower professional fees and compensation expense. Our net interest margin or NIM for the quarter was 1.02%, excluding the impact of the catch-up premium amortization, our adjusted NIM was 1.12% or 5 basis points lower than prior quarter. The average yield on our portfolio increased 11 basis points to 3.26%, while our cost of funds increased 16 basis points to 2.14% driven by higher repo borrowing rates as LIBOR continued to rise. At the end of the third quarter, we had total equity of $170.2 million or $13.40 per share as compared to $174.2 million or $13.70 per share at the end of the prior quarter. Our economic return for the quarter was a positive 0.5% or 2.1% annualized. Next, please turn to Slide 7, which shows a summary of our portfolio holdings as of September 30, 2018. Our overall RMBS portfolio size was essentially unchanged at $1.58 billion as of September 30, 2018 versus June 30, 2018. In addition, our debt to equity ratio was 8.8:1 as of September 30 and June 30, 2018. Next, please turn to Slide 8 for detail related to our interest rate hedging portfolio. For the third quarter, our interest rate hedging portfolio continued to consist predominantly of interest rate swaps and short positions in TBAs and to a lesser extent, short positions in the U.S. Treasury securities and futures. In our hedging portfolio, the relative proportion based on 10-year equivalents of short positions in TBAs decreased quarter-over-quarter relative to our other interest rate hedges. As you can see in the chart on the left, TBAs represented 20.8% of our hedging portfolio at the end of the third quarter as compared to 25.1% at the end of the prior quarter, which is shown in the chart on the right. The reduction in our TBA hedging positions has some important consequences. And for that, please turn to Slide 9. Our net exposure to RMBS, which is the aggregate market value of our RMBS holdings, including our net short TBA positions was $1.35 billion as of September 30, 2018, which translates to a net mortgage assets to equity ratio of 7.9 to 1. This was up from prior quarter when we had net exposure to RMBS of $1.29 billion and net mortgage assets to equity ratio of 7.4 to 1. This marks the highest level that our net mortgage assets equity ratio has ever been reflecting our constructive view on agency RMBS relative to other fixed income instruments. For the quarter, we repurchased 21,720 common shares at an average price per share of $10.56 per share and at an average discount to book value of 21%. More significantly with our stock price lower since quarter-end, we have repurchased an additional 108,339 shares so far in the fourth quarter through Friday, November 2. I would now like to turn the presentation over to Mark.

Thanks, Chris. Q3 was characterized by an orderly book material and move higher interest rates. The 10-year note is consistently close to above 3% yield, since mid September. The cumulative impact of generally strong economic numbers, Fed rate hikes and Fed balance sheet reduction, also known as quantitative tightening, have all acted in concert to push the 10-year note across that threshold 3% level. In many ways, the market is behaving in 2018 in a way that's much more consistent with historical norms than 2017 was. In 2017, despite Fed rate hikes, generally good economic numbers and start off balance sheet reduction tenure rates barely moved. Now with the shrinking Fed footprint, interest rates have reverted back to a more traditional relationship to economic numbers. We ended the quarter with a generally favorable view of the relative value of mortgages compared to treasuries and swaps, and so we added about half a ton of net mortgage exposure going from 7.4 to 7.9 times. We made no major portfolio composition changes other than our continued focus on turnover and seeking relative value opportunities in the specified pool market. Higher interest rates and wider mortgage spreads are giving us the best opportunity in years to increase our portfolio yields. Agency MBS modestly outperformed hedging instruments in the quarter, tightening a couple of basis points relative to rates. For the quarter, there was a more substantial tightening in other spread products, however. We view this as a favorable environment for mortgages. The payment risk is very low, and so is the cost of hedging against that risk. We don't see much negative policy risk and mortgage spreads relative to other alternatives, such as investment paid to corporates and other asset-backed spread products looked pretty wide. Additionally, specified pool pay-up seemed roughly in line versus TBAs, and there are pockets of value. The big negative is Fed balance sheet reduction. But it is important to remember that balance sheet reduction impacts both MBS and treasuries. So it's currently implemented. Balance sheet reduction should affect more the absolute level of interest rates as opposed to relative value of Agency MBS versus treasuries. While the relative com of the third quarter was shattered once we entered the fourth. Q4 has been characterized by increased interest rate volatility, truly extreme equity volatility and the broad-based underperformance of spread products versus treasuries. Look at Slide 10. Here we show the Barclays MBS Index, OAS; the Corporate Index, OAS; and the high-yield index, OAS. All are gapped wider since quarter-end. That's why so many agency mortgage REITs – that's why in so many agency mortgage REIT earnings calls, you have heard estimates of October book value declines in the 4% range. Our book value is down, too, in October, but I'm betting that we have faired better than the rest of the group. So what has all this done to the current opportunity set? It's made it much better. The underperformance of Agency MBS so far in Q4 has had nothing to do with changes in prepayment risk, policy risk or a sudden surge of supply. In any – if anything, we expect mortgage supply to come down in the coming months with the seasonal slowdown in mortgage origination and the observed decrease in both existing and new home sales. Repo funding levels are also pretty attractive, and you don't need to take a lot of prepayment risk to get healthy net interest margins. Every 10 basis points of widening in MBS is worth about 80 basis points in leverage net income margin, assuming that each dollar of capital supports $8 of mortgages. So despite any declines in book value, which we work hard to guard against, in exchange for MBS widening, Agency mortgage REIT investors get higher future expected returns. This is in sharp contrast, for example, through an increase in loss expectations for bank loans and high-yield bonds that lead to widening in spreads in those markets because those spreads are quoted on a no-loss basis. While we don't have the ability to predict when this outer spread widening will end and it can certainly get worse when you take into account low specified pool pay-up risk, low prepayment risk, low funding cost relative to LIBOR, the leverage NIM available today in Agency MBS is in many ways the best quality NIM we've seen in years. We are absolutely focused on capturing that NIM for our shareholders. Now back to Larry.

Thanks, Mark. I'm pleased with our earnings performance so far this year. And I'm especially pleased with the stability of our book value in what has been a very challenging operating environment for Agency mortgage REITs. As we look ahead to the remainder of 2018, I like how we're positioned, and I'm excited about the opportunities. As we've mentioned on the call today, we have used the recent market volatility and widening of our RMBS yield spreads to increase our mortgage exposure. And fortunately, our strategy has enabled us to do this in a relatively simple and low-cost fashion, namely, just by covering some of our TBA short positions. As usual, we're also turning over the assets under the balance sheet, and this enables us to add specified pool assets at the new hire yields, thus recharging our NIM. Our liquid portfolio and smaller size enable us to move nimbly in and out of position and to dial up or down our mortgage exposure quickly, based on changing market conditions. During the quarter, with interest rates rising and MBS yield spreads widening, EARN again outperformed the peer group both on a quarter-over-quarter and on a year-to-date basis. Of course, the market challenges have only intensified during the first weeks of the fourth quarter, as volatility has spiked and the Agency yield spreads have continued to widen. These developments again underscore the importance of EARN's commitment to active portfolio management and disciplined hedging across the curve to preserve book value. We believe that we have the team, the strategy and the proprietary resources to perform across market cycles, and we believe that market dislocations only magnify our comparative advantages. 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. With a differentiated approach to hedging interest rate risk and managing the portfolio, we believe we continue – we can continue to drive shareholder value into 2019. With that, we'll now open the call to your questions. Operator, please go ahead.

[Operator Instructions] The first question will come from Doug Harter with Credit Suisse.

Thanks. You've just talked about kind of the ability to take advantage of the current wider spreads. Can you talk about where you would be comfortable taking your kind of net mortgage exposure or net mortgage leverage?

Doug, it's Mark. So the first thing, I would say, is that we want to see some stability in spread products before we would do that. There was, obviously, huge amount of volatility in October. We reference to slide where this spread widening was broad-based across fixed income. It wasn't mortgage specific. So condition one, seeing some more stability, and looks like we're just starting to get that. I definitely could see adding another turn of leverage, something like that.

Got it. And then I guess, as you kind of look forward and think about kind of the composition of the hedged portfolio, kind of, as you – if and when you add kind of additional risk to the portfolio, how would you anticipate that hedged portfolio changing?

We are constructive on mortgages coming into the end of the third quarter, and you saw that reflect in our positioning. Obviously, things are wider now. When I talk about potentially adding a turn of leverage, what I mean is really mortgage exposure, right? So mortgage exposure versus treasuries or swaps. So if we would do that, then you'd see the percentage of hedges in – and mortgages drop a little bit on a percentage basis.

And just to add to that, just keep in mind, we quote this net mortgage assets to equity ratio and it's – as of quarter-end, it was at 7.9 to 1. So keep in mind that's asset-to-equity are not debt-to-equity. So if that 7.9 number, if we were to – I think in terms of the amount of actual borrowings that we have, I don't see us really, as Mark sort of just implied, I don't see us increasing that number. The way we would get the exposure is by reducing our TBA shorts from what they are currently now, which is 20% of our hedges, which is the lowest that they have been. And in theory, right, if you want to put an upper limit on it, I could say, let's say, theoretically go down to zero, but if we really were at our extreme position on – in terms of being constructive on mortgages. So you could see that would put our net mortgage assets to equity ratio above 9 in that case. But that's sort of I think the upper limit on where we could go because we would be at our repo leverage, which is I think – we feel that we wouldn't want to go much higher than we are now, just as prudent liquidity management, and then in terms of not having any TBA shorts at all that would put us there. And again, that's not that 9 or more than 9 number would not be debt-to-equity, just to be perfectly clear, that would be assets-to-equity in that case.

Make sense, thank you.

The next question will come from Mikhail Goberman with JMP Securities.

Thank you for taking my question and congratulations on a solid quarter in a difficult environment. Question number one, have you guys mentioned, I think, in Slide 11 here the spread between the repo funding and the LIBOR? Could you quantify that benefit that you received in the third quarter? And perhaps, to get a sort of peek at fourth quarter potential?

Sure. So – this is Mark. So the way you read that slide is, as the blue line goes up that means the interest rate we're receiving on the floating leg of the swap, if we're paying fixed and receiving floating, it's the difference that and the repo cost, right? If you go back to beginning of 2016, the repo costs were higher than what we were receiving on that floating leg of the swap. Now you can see the repo costs are lower than what we've been receiving. So earlier in the year, there was a big spike, where it was a tremendous tailwind. It's come in a little bit. Fourth quarter, I think the number so far has come down a little bit. We’re going to be doing a bunch of rolls in the coming week. So we’re going to need another data point. But I think that, in general, if you look at sort of – think about a moving average or something of this, you are adding – if you just look at sort of mortgages on a spread to the curve or OAS on mortgages, that doesn’t give you the full story for a REIT because you are using leverage. And so you really need to add into the mortgage spread this differential, whether it’s positive or negative. And right now, it’s positive.

Yes. And if you look at the – we don’t have the exact number you’re looking for in front of us now. But if you look at the graph on Page 11, you can see that, that funding advantage versus LIBOR came down, right, during most of the quarter and averaged somewhere in the teens. But you can see that, if you look now more on a spot basis at the very end of the graph, there you can see now it’s in 20s. So that’s kind of the nice tailwind going forward.

Got it. So perhaps a bit higher benefit in the fourth quarter towards the end of the quarter because this rate is trending upwards, you’re saying?

Correct. And – well – or at least, it’s higher than it is now. I don’t want to predict where it’s trending. But the – yes, and we have now more of our hedges as we mentioned in swaps versus in TBAs. And so we’re going to see that benefit in terms of the payments that we were receiving, right, on the swaps because we received the LIBOR floating leg and we paid the fixed leg. So we’re going to see the benefit quite directly in higher LIBOR payments that we receive relative to our funding cost, that differential, which really goes right to the bottom line you can see is now currently much higher and giving us that tailwind than it was on average through the third quarter.

Great. Thanks a lot. And just a quick ubiquitous question on share repurchases over, I guess, none in the third quarter. Any sort of appetite or pace going forward?

Sure. Yes. So far, we repurchased, like we said through last Friday, over 102,000 shares at this current equity or the current discount that we’re trading to the market price. Yes, we’re right around that level. Our remaining authorization under the plan is 1 million shares.

Yes, we typically have set pursuant to 10b5-1 programs. We typically set levels where we want to buy stock, right? These are automated programs so that we can repurchase during blackout periods. And it’s – we often tier things. So that will buy a certain amount of stock down to a certain level, price-to-book level. And then there will be another tier below that where we will buy more. So that we were – that our stock price declined in the beginning of the fourth quarter is why we’ve been able to buy over 100,000 shares back after the fourth quarter, even though we were in a blackout period.

And we did buy back a little amount of shares in the third quarter, which is over roughly around 22,000 shares.

Okay. Thank you very much gentleman. Appreciate it.

Thank you.

At this time, there are no further questions. Ladies and gentlemen, thank you for participating in today’s conference call. You may now disconnect.