Ellington Credit Company (EARN) Q4 2018 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2018 Fourth Quarter and Full Year 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 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 provision 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 statement, 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 fourth quarter earnings conference call presentation is available on our website, www.earnreit.com. 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. We appreciate your time and your interest in Ellington Residential. On our call today, I'll first give an overview of the fourth quarter. Next, 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. And finally I'll provide some brief closing remarks. Then we'll open the floor to questions. During the fourth quarter a confluence of factors steadily weighed on the market including fears of a looming trade war, recessionary and global growth concern and worries that the Federal Reserve and other central banks were finally ending their accommodative monetary policies, market volatility spikes including interest rate volatility. All this led to a slide to quality. The 10 year treasury declined 55 basis points over the last seven odd weeks of the year and yield spreads in virtually every fixed income sector wide and relative to treasuries and interest rate swaps with many sectors finishing the year at or near their two year widest levels. The decline in interest rates and the high levels of interest rate volatility generated net losses on our hedges and while our Agency RMBS assets did appreciate in price with the decline in interest rates, their widening yield spreads caused them to underperform our hedges. We finished the quarter with a GAAP loss of $0.80 per share. However, and very importantly, much of that GAAP loss was merely the result of the mark-to-market effect of the wider yearend yield spreads. In January, some of that yield spread widening reversed itself. And as a result, we estimate that our book value per share in January recovered by about $0.45 per share or over 3.5%. Most importantly, the wider yield spreads we're seeing are providing excellent investment opportunities and the outlook for our future adjusted core earnings is strong. Now turning to our presentation and beginning with slide three in the top section of that slide, as I noted the previous trend of rising interest rates reversed course during the fourth quarter, with rates dropping across the yield curve. The spread between the two year and the 10 year collapsed to just 20 basis points as compared to 52 basis points year earlier. LIBOR on the other hand, continued its upward stat. In the lower sections you can see not only the higher prices on Agency RMBS this quarter, which were rate-driven, but also their wider yield spreads. For example, on the second to last row you can see that the raw yield spread on Fannie Mae 4s, widened by 14.7 basis points over the course of the quarter, which is considered a very large move. Turning to Slide 4, for the fourth quarter of 2018 EARN reported a GAAP net loss of $0.80 per share, but we were able to maintain adjusted core earnings at $0.32 per share. Similar to last quarter, we took advantage of wider RMBS yield spreads mostly by covering a portion of our TBA shorts but also by rotating out of a bunch of lower yielding pools into higher yielding pools including higher coupon pools. With this more aggressive positioning we ended the quarter with a net mortgage assets to equity ratio of 8.7 to 1, which is the highest ratio we'd ever run and our debt to equity ratio also increased to 9.6 to 1 as compared to 8.8 to 1 last quarter. As we said in the past we want to dial up or down MBS exposure aggressively in response to market opportunities. And the market selloff in the fourth quarter was one of those opportunities. In our view, Agency RMBS valuations were as attractive at that time as they had been in over two years, all the more so in a benign prepayment environment. I believe that our estimated January book value up approximately $0.45 for the month bears that view out. During the fourth quarter we also took advantage of our discounted stock price by repurchasing all under our 10b5-1 plans over 1.5% of our outstanding shares at steep discounts to our book value per share. We will continue to consider opportunities to repurchase shares accretively in the future. Also for the fourth quarter the Board declared a dividend of $0.34 per share, which equates to an annualized dividend yield of 11.7% based on yesterday's closing price of $11.64 per share. And now I'll turn the call over to our CFO, Chris Smernoff to discuss our financial results in greater detail.

Thank you Larry and good morning everyone. Please turn to Slide 6 for a summary of EARN's financial results. For the quarter ended December 31, 2018 we recorded a GAAP net loss of $10.1 million or $0.80 per share and adjusted core earnings of $4 million or $0.32 per share. These compared to GAAP net income of $946,000 or $0.07 per share and adjusted core earnings of $4.1 million which was also $0.32 per share for the quarter ended December 30, 2018. Our adjusted core earnings exclude the catch up premium amortization adjustment which totaled $31,000 in the fourth quarter and negative $398,000 in the third quarter. During the fourth quarter our declining interest rate and high level of interest rate volatility generated losses on our interest rate hedges and we reported a net loss for the quarter as these hedge losses exceeded net income and gains on our Agency RMBS investments. Net realized and unrealized gain on our RMBS was $10.8 million and total net interest income was $4.8 million whereas our net realized and unrealized loss on our interest rate hedges totaled $24.9 million. For the fourth quarter our annualized operating expense ratio was 3% in line with the prior quarter. Turnover for our Agency RMBS portfolio was 22% in the fourth quarter as compared to 18% in the prior quarter. Our net interest margin or NIM for the quarter was 1.12%. Excluding the impact of catch up premium amortization our adjusted NIM was 1.11%, down 1 basis point from the third quarter. The average yield on our portfolio increased 20 basis points to 3.46% as we rotated part of our portfolio to take advantage of the yearend opportunities, while our cost of funds increased 21 basis points to 2.35% driven by higher repo borrowing rates as LIBOR continued to rise. At the end of the fourth quarter we had total equity of $153.8 million or $12.30 per share as compared to our $170.2 million or $13.40 per share at the end of the prior quarter. Our economic return for the quarter was negative 5.7%. Next please turn to Slide 7, which shows summary of our portfolio holdings as of December 31, 2018. Our RMBS portfolio decreased slightly to $1.54 billion as of December 31, 2018, compared to $1.58 billion as of September 30, 2018. Although our portfolio was small, quarter-over-quarter our equity base was also small and overall debt to equity ratio adjusted for unsettled purchases and sales increased to 9.2 to 1 as of December 31, 2018 from 8.7 to 1 as of September 30, 2018. Next please turn to Slide 8 for details on our interest rate hedging portfolio. For the fourth quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps, short positions in TBA and US Treasury futures. TBA short positions represented 14.9% of our hedging portfolio at the end of the fourth quarter as compared to 20.8% at the end of the prior quarter. As I mentioned last quarter, the reduction in our TBA hedging positions had some important consequences and for those 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 position was $1.34 billion as of December 31, 2018, which translates to a net mortgage asset to equity ratio of 8.7 to 1. This was up from prior quarter when we had a net mortgage asset to equity ratio of 7.9 to 1 reflecting our bullish outlook on Agency RMBS valuations at year end. Finally, we repurchased 202,493 common shares during the quarter at an average price of $10.54 per share for a total cost of $2.1 million with a total accretive effect of $0.04 to book value per share. I would now like to turn the presentation over to Mark.

Thanks, Chris. The fourth quarter was characterized by extreme volatility in all financial markets, stocks dropped sharply, interest rates declined and credit spreads widened as markets questioned the wisdom of successive Fed rate hikes against the backdrop of slowing global growth, the uncertainty of rising trade tensions and the government shutdown. What made Q4 uniquely challenging was the magnitude of the moves and the high degree of correlation between asset classes with different fundamental risks. At EARN we always focus on two goals, preserving book value and driving return. While we are disappointed with our negative economic return for the quarter, much of that return was the result of UN markdowns during the time of extreme volatility and forced liquidation exacerbated by year-end balance sheet constraint. Much of the book value decline we suffered was the result of yield spread widening that is to say the underperformance of Agency MBS compared to interest rate hedges. Virtually any leverage fixed-income securities portfolio constructed to generate core earnings separate a Q4 draw down because of synchronized widening spreads across nearly all fixed income products. So the widening was not even Agency MBS specific. In the midst of the Q4 volatility, we stuck to the investment process we’re known for, go back overall your fundamental analysis, control your risk, challenge your investment hypothesis but if your investment hypothesis is reaffirmed, once that is all done, try to seize the opportunity and that's what we did. The depressed Agency MBS valuations during the fourth were not result of a fundamental change in prepayment expectations. As is often the case with Agency MBS and other spread products, yield spread widening losses can be reversed with the change in market sentiment and that's exactly what happened in January when dovish messaging from the Fed soothed the stock and bond market. And we estimate that we made back about 60% of our Q4 economic loss in just one month. This ability to recover spread widening losses is a significant differentiating attribute of Agency MBS relative to most other credit strategies, where increasing defaults can cause unrecoverable credit losses. Additionally, many of our portfolio moves in Q4 positioned us well for the New Year. As shown on Slide 8 as Agency MBS underperformed treasuries in Q4 we shifted more of our hedge away from TBA mortgage securities and into swaps and treasuries. This helped us so far this year as Agency MBS have outperformed. On Page 9 you can see the mortgage to equity exposure increased in the quarter from 7.9 to 8.7. While we didn't know when they would recover we thought that wider mortgage spreads were a great entry point to adding additional turn of leverage of mortgage exposure. As often happens in volatile markets liquidity premium increased as investors unnerved by big price swings seek the comfort of price transparency over fundamental value. That's exactly what happened in December as specified pools underperformed TBAs. While specified pools are very illiquid -- are very liquid, they are not as liquid as TBAs and in the extreme volatility of December they underperformed. Since the year end however specified pools have outperformed TBA. There is recently been a very interesting dynamic in Fannie's and Freddie's that if it persists we think we will continue to drive specified pool performance. Look at Slide 10, which shows the change over time in the WAC versus the coupon pass through rate for the various Fannie Mae major pools. You can see that there's been a big WAC spread increase over time in virtually every coupon and this WAC spread increase is happening in a time when the Fed is no longer net adding MBS exposure, so the Fed can’t be the final resting place of all the least attractive or cheapest to deliver mortgage pools as they were during the height of QE. Without the Fed indiscriminately buying other investors need to own these less attractive higher WAC pools and so this increase in WAC spread is holding down low levels and benefiting specified pools more than TBAs. You can see on Slide 15, despite sharply higher interest rates in early Q4 we do not materially change the composition of prepayment protection in our specified pools, instead we actively traded market inefficiencies leaving the quality of prepayment protection intact. The portfolio we brought into Q4 volatility had a lot of prepayment protected specified pools inflating our assets from the increased prepayment expectations on to the recent drop in interest rates. Increases in market trading opportunities is one of the silver lining of the recent increased volatility. And as Chris mentioned, our turnover increased from 18% to 22% in Q4. Markets were less liquid, especially towards the end of December and that created dislocations in relative value opportunities that we were able to take advantage of. Meanwhile repo markets in 2019 have also been very favorable with three months repo rates about 10 basis points less than three month LIBOR. Our financing team did very good job managing our borrowing costs over year end, avoiding the spike in financing rates that occurred in late December. Looking forward at a slightly more balanced outlook from the Federal Reserve, which mainly have been sitting on their hands much of the year should be a tailwind for mortgage performance. It may create less interest rate volatility and leave interest rates in the familiar trading range which mortgages generally like. And the more balanced Fed approach largely takes off the table the scenario that scared the market most of last year, mainly continued Fed hikes driving 10 year notes -- 10 year note rates well up beyond 3.25%. Sharp increases in interest rates generally lead to periods of significant MBS underperformance like the Taper Tantrum in 2013. In January we’ve already seen the wider yield spreads at the end of Q4 transferred into some combination of better net interest margins and mark-to-market gains. So the market has moved past fears of a hawkish Fed. However, the other Q4 worries of slowing global growth and trade war uncertainty are still very much with us. We think this may create consistent demand for Agency MBS as investors seek fixed-income yield without a lot of credit risk. Now back to Larry.

Thanks Mark. In 2018 our EARN was able to withstand several periods of extreme volatility, thanks to disciplined hedging and portfolio management. While the volatility in the fourth quarter represented a near-term challenge, it also created a tremendous investment opportunity and we positioned ourselves accordingly, by dialing up our mortgage exposure aggressively. So far this year that positioning has been rewarded. So despite the swings in the past few months our investment approach remains unchanged. Disciplined interest rate hedging and rigorous asset selection informed by years of our portfolio management and prepayment modeling. Our differentiated strategy gives us the ability to deliver returns in a diversity of market environment and to preserve book value in times of volatility. We look forward to the market opportunities ahead in 2019. And with that, we will now open the call to your questions. Operator, please go ahead.

[Operator Instructions]. Your first question comes from the line of Sam Choe of Credit Suisse.

So you guys talked about ramping up MBS allocation given the level of attractiveness in the space. I was just wondering you did touch on leverage but what's the flexibility there and where do you see it heading throughout the year?

Yes, well of course where we see it heading I think that is going to be very market dependent, but I think that where our -- just looking at a debt to equity, but we have two metrics right that we look at, one of them is debt to equity and one of them is net mortgage assets to equity. Net mortgage assets to equity we still had some room there, because we still had TBA shorts, we don't have to have TBA shorts but they were greatly reduced dropping below 20% of our total hedging portfolio for the first time, perhaps ever since our IPO. Now on the debt to equity side, I think similar to what we said in the last earnings call, in the nine handles it's probably the highest that we would go. I don't think we would go above 10 to 1 of course, on a very short-term basis, anything is possible. But in general I think it sustained debt-to-equity ratio above that. It's not something that we've done before and I don't think it's something that we would do I guess absent extraordinary measures.

Okay, that's great color. One more from me. So you guys also talked about the volatility within the fourth quarter. Just wondering if there were any key takeaways on the risk management front that you could -- during the fourth quarter that you can apply throughout the year to maintain stable book value positioning?

Yes, so this is Mark. Every day we follow the same process. So we run risk metrics overnight and we also have measures that tell us how our risk measures change minute to minute as a function of changes in market rates. So the same process that we do when the 10 year notes not move in very much is the same process we followed in December. But in December, when you have larger interest rate moves it requires a little bit more delta hedging. So I think we try to manage book value volatility with two primary tools. First tool is asset selection, so by buying pools that have a return of cash flow in different rate environments more like a corporate bond, so things that are prepay protected, in some cases extension is protected, so trying to buy mortgages that looked more like a corporate bond and sort of your garden-variety mortgage. That's one thing we do. And the other one is to adjust the size and we’re on the curve the interest rate hedges are as a function of changes in interest rates and changes in shape of the yield curve. So those are the two leverage we use, it served us very well. What you had in Q4 was synchronized across the board combination of spread widening and underperformance of specified pools relative to TBA. So spread widening risk is something we’re comfortable with and it’s sort of a necessary risk to take to generate the dividend which is essentially levering core earnings, but the tools we use to try to mitigate book value losses that aren’t recoverable, that don’t mean revert is pool selection which protects you from prepayment volatility and interest rate hedges across the curve that are adjusted daily or in some cases hourly in response to market moves.

And I think I’ll just follow up on one thing if you turn to Slide 5 in the presentation, to just simplify on what Mark said. If you compare this to our slide of the prior quarter, right, one thing that we have been noting or have been noting I should say for a while is that the relative value of what you look over let’s say the trailing 24 months of Agency RMBS looks very good relative to a lot of spread products, other spread products in the credit sector have looked relative tighter compared to the 24 months history and Agency RMBS looked like in spite some metrics better value and more prone to further strengthening. So we’ve been positioned accordingly. We have been reducing our short positions in TBAs accordingly. And -- but then as Mark mentioned during the -- his scripted part, the spread widening that we saw was really across the board in the fourth quarter. It wasn't just limited to Agency RMBS by any stretch in fact, probably even more pronounced in some of the other sectors. So that’s something that is I think much harder to anticipate and across the board spread widening it’s going to be triggered by a lot of factors that are just much, much more difficult to predict. So there I think that it made sense the way on a relative basis agencies versus other sectors where we were positioned going into quarter. And we just had across the board spread tightening.

Your next question comes from the line of Mikhail Goberman of JMP Securities.

So kind of a big picture macro question. It seems like a pretty good environment right now for mortgage investing with the Fed where it is and a range bound sort of 10 year and political gridlock, what is it that kind of keeps you up at night, what you guys are worried about the most in this kind of environment?

So one thing we tried to show with that slide that documents the WAC deterioration that is a result of a combination of factors. The same coupon agency mortgages, if you think about Fannie 4s, Fannie 4s now are a little bit more refinanceable than they used to be for the same level of rates by virtue of the fact that the underlying mortgages that are contributing to a Fannie 4 have a higher note rate. So there is that trend you’ve seen this a little bit of erosion in pool quality, but it’s the fact that that erosion in pool quality comes at a time when the Fed is not the final resting place, I think is what we said for these most negatively convexed mortgage pools that have been creating. When the Fed was buying the worst 10% or 15% of pools being produced were basically irrelevant because it was just winding in the Fed portfolio and you only need investors to have capital for the remaining pools that were better quality. That dynamics change, that dynamic is creating lower roll levels relative to the level of financing and I think that’s one of the reasons why you’re seeing some agency REITs that have had a strong -- that a lot of times had big TBA positions rolling them might be getting back to specified pools. So I think that that -- the one thing with these higher note rate mortgages getting made and it’s not really so much in Ginnie space and Fannie/Freddie space, that's a little bit of a headwind. And the other thing I would say and I alluded to it a little bit at the end of my prepared comments that you the dovish Fed certainly changed the way many investors view the mortgage space and you said range bound, investors like it, mortgages are right now at dollar prices that we've seen a lot over the last couple of years. So that makes prepayments more predictable. So that’s a really positive trend. The other factors which cause spread volatility in Q4, we talked about trade war uncertainty. We talked about slowing global growth. Those are the factors haven’t really been solved. So I think if you get a big risk off move in credit sectors may be high yield or bank loans that what you saw in Q4, there is going to be a little bit of a knock on effect. So I think the risks to that are lower right, because dovish Fed is certainly a big factor, but that's another thing that we have to be cognizant of.

Thank you for the answer. That's very helpful. And just a quick question on buybacks, you repurchased a little over 200,000 shares on the quarter. How much do you have left in that authorization, just curious?

Sure, this is Chris. We have over 1 million shares left under the current authorization.

Alright, thank you very much, guys.

[Operator Instructions] Your next question comes from the line of George Bahamondes of Deutsche Bank.

Do you have any dividend carryover?

So no, I don't think so. So in other words -- sorry -- so the dividends that we declared for 2018 right, are all reflected, correct, on the 2018 1099. So including the one that was paid in January, correct?

So no, the one that was paid in January is …

Right, exactly, sorry, Okay fine, so that answers the question. So if you look at 2018-1099 you'll see only their dividends are actually paid in 2018, so I think that answers your question.

Yes. That's what I was looking for there, thank you.

And just sorry, I just wanted to just throw one more thing in there. So the rules for treating when you terminate -- got to get a little technical on that but when you terminate a hedging position, initially hedging position in a REIT, there are certain rules as to how you take that loss and sort of how you amortize it over time. And what happens is that the loss is not all taken at once. If you have a hedging loss and the gain is now taken once again there isn't any gain. So one phenomenon that happens is that that happened in 2018 for example is that hedging losses that had occurred previously were amortized during 2018, some of that occurred before 2018, so what that did was that reduced taxable income of the company in 2018 which is actually a good thing because it means that it doesn't put stress on the dividend in terms of having to over dividend. So dividending out something that isn't really economic income. So in that sense our 20 -- the dividend that we paid in January 2019 can be applied against our 2019 taxable income.

Got it, I guess just a follow up on the dividend. I understand that the investment environment is a bit more attractive this quarter relative to what it may have looked like in 2018 just given some of the widening that we've seen with Agency MBS. As you think about the dividend and maybe the core EPS run rate if you will and just kind of looking at the performance of the past four quarters or so, are you comfortable with the current $0.34 dividend relative to your borrowing cost and where you're able to get the portfolio yield in the current environment?

Yes, and in fact there's more that we can do on the portfolio side. We mentioned the rotation in the fourth quarter that actually increased our asset yields despite the fact that rates actually were dropping in the fourth quarter, there was actually more of that. As we rotate the portfolio I think we'll see a little more of that which should booey core even more, but we sized the dividend so that we believe that we can cover it respectively.

Thank you, operator.

Thank you for participating in the Ellington Residential Mortgage REIT's 2018 fourth quarter and full year financial results conference call. You may now disconnect your lines and have a wonderful day.