Ellington Credit Company (EARN) Q1 2019 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2019 First 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 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 8, 2019, 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 first quarter earnings conference call presentation is available on our website, earnreit.com. Our comments this morning will track the presentation. Also a reminder, during this call, we will 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’ll begin with an overview of the first 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, and then we’ll open the floor to questions. During the first quarter, the overall market weakness of the previous quarter reversed course and most fixed income and equity assets performed well. Dovish messaging from the Federal Reserve sparked a rally in the stock and bond markets, with market volatility declining and yield spreads tightening on most credit assets and many agency assets. Interest rates were range-bound for the first two months of the quarter before dropping substantially in March. The Federal Reserve appeared to end its rate-hiking cycle and also announced a slowdown of its balance sheet runoff. In Europe, the ECB introduced new stimulus measures in response to slowing growth, including a recession in Italy. As you can see on Slide 3 of the presentation, by quarter-end, the yield on a 10-year U.S. Treasury note had declined to 2.41%, down a whopping 83 basis points from November 8, when it closed at 3.24% which had been its highest level since 2011. Meanwhile, the yield curve continue to flatten, with a portion of the curve even inverting for a week in March, again, stoking fears of a full yield curve inversion, and whether that might signal a looming recession. Mortgage rates fell sharply in the first quarter. The Freddie Mac survey 30-year mortgage rate declined 49 basis points to end the quarter at 4.06%. The strong performance of Agency RMBS helped drive our results this quarter, and the recent decline in mortgage rates and corresponding increase in prepayment expectations boosted tremendous value of the prepayment protection that our specified pools provide. In contrast, the generic pools that underlie TBAs tend to be more prepayment-sensitive. Because we concentrate our long investments in specified pools as opposed to TBAs, the increase in specified pool pay-ups greatly benefited our performance. Turning next to Slide 5. We reported net income of $0.72 per share and a strong economic return of 5.9% for the quarter, or almost 26% annualized. Adjusted core earnings was $0.27 per share in the first quarter, which was down from the prior quarter, primarily due to an increase in repo borrowing rates. Short-term LIBOR rates were higher in the first quarter than they had been in most of the third and fourth quarters of last year. And as many of our lower-cost borrowings, which were initiated when short-term LIBOR rates were lower, when these have matured, they’ve been replaced by borrowings based on more recent higher short-term LIBOR rates. Another reason for our lower quarter-over-quarter adjusted core earnings is illustrated on Slide 6, which shows a time series of three-month LIBOR versus our three-month repo rates. Because we receive three-month LIBOR on our interest rate swaps, whenever our repo borrowing rates fall below three-month LIBOR, we get paid more on the floating legs of our swaps and we’re paying out on repo, which can be a significant tailwind for our earnings. And as you can see on this graph, we’ve had that tailwind during most of the past three years. However, in the first quarter, this relationship flipped, with repo costs again exceeding three-month LIBOR. This phenomenon is increasing our net hedging cost and reducing our net interest margin. 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 7 for a summary of EARN’s financial results. For the quarter ended March 31, 2019, we recorded GAAP net income of $8.9 million, or $0.72 per share, compared to a GAAP net loss of $10.1 million, or $0.08 per share for the fourth quarter of 2018. Adjusted core earnings was $3.3 million, or $0.27 per share, compared to $4 million, or $0.32 per share for the prior quarter. Our adjusted core earnings excludes the Catch-up Premium Amortization Adjustment, which was a negative $944,000 in the first quarter of 2019, compared to a positive $31,000 in the prior quarter. The Catch-up Premium Amortization Adjustment was negative this quarter, because declining mortgage rates caused expected repayments to increase. During the first quarter, declining interest rates and tightening yield spreads on many Agency RMBS generated net realized and unrealized gains on our RMBS investments totaling $20.5 million. These gains were partially offset by net realized and unrealized losses on our interest rate hedges, which totaled $13.9 million. Average pay-ups on our specified pools increased to 0.99% as of March 31, 2019 from 0.58% as of December 31, 2018. Our non-Agency RMBS portfolio also performed well during the quarter, driven by strong net interest income and net unrealized gains. For the first quarter, our annualized operating expense ratio was 3.5%, and we projected to settle in the range of 3.3% to 3.4% for 2019. Turnover on our Agency RMBS portfolio was 16%, as compared to 22% in the prior quarter. Our net interest margin, or NIM, for the quarter was 0.83%. Excluding the impact of Catch-up Premium Amortization, our adjusted NIM was 1.08%, down 3 basis points from the prior quarter. As a result of portfolio turnover, the average yield on our portfolio increased by 15 basis points to 3.61%, while as a result of rolling lower cost repos that came due, our cost of funds increased by 18 basis points to 2.53%. At the end of the first quarter, we had total equity of $158.2 million, or $12.69 per share, as compared to $153.8 million, or $12.30 per share at the end of the prior quarter. Our economic return for the quarter was 5.9%. Next, please turn to Slide 8, which shows the summary of our portfolio holdings. Our RMBS portfolio decreased slightly to $1.49 billion as of March 31, 2019, compared to $1.54 billion as of December 31, 2018. Although our portfolio was smaller quarter-over-quarter, our equity base grew, which resulted in lower leverage. Our overall debt-to-equity ratio adjusted for unsettled purchases and sales decreased to 8.9:1 as of March 31, 2019 from 9.2:1 as of December 31, 2018. Next, please turn to Slide 9 for details on our interest rate hedging portfolio. During the first quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps, short positions in TBAs and U.S. Treasury futures. The size of our TBA short positions increased slightly during the first quarter to 15.4%, as compared to 14.9% at the end of 2018. Turning now to Slide 10. 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 March 31, 2019, which was unchanged from the prior quarter. This translates to a net mortgage asset to equity ratio of 8.5:1 at March 31, 2019, compared 8.7:1 at December 31, 2018. I would now like to turn the presentation over to Mark.

Thanks, Chris. Q1 was a very strong quarter for EARN. We made back just about all the Q4 2018 drawdown and have a portfolio in a market environment that we think is very conducive to future strong performance. On our Q4 call, we said that we believe that the underperformance of Agency MBS was largely technical and not driven by fundamentals, so we kept our MBS exposure higher than historical levels and that positioning has really paid off. In many cases, sharp interest rate moves are a problem for MBS performance, but that wasn’t the case this time around, as specified pools performed extremely well in the rate rally. The MBS market is typically aided by a narrow interest rate range, which keeps the lid on delta hedging costs and supports maximal net interest margin capture. But the dovish pivot in Central Bank messaging this quarter was the dominant market theme, supporting net interest margin capture even as rates dropped and prepayment concerns increased. While our portfolio benefited from the spread tightening that occurred across most fixed income products, generic MBS actually underperformed corporate bonds significantly. Look at Slide 11, which showed the spread of TBA Fannie 3.5s and the spread of the on-the-run IG corporate index. You can see that MBS spreads materially lag corporate bonds in Q1 in the tightening. That is why we think MBS is still well positioned to continue their strong performance at current spread levels. In fact, even if corporate bonds were to widen 10 to 15 basis points from here, we think that MBS would still look fairly valued and they would look attractive on a relative basis should corporate bond spreads hold firm at current levels. Both the Federal Reserve and the ECB took to surprisingly dovish stokes in the quarter. It was only last October when Fed Chair Powell said that rates were a long way from neutral, which quickly led to multi-year high yields in U.S. interest rates. In the short five months, 10-year yields rallied more than 80 basis points and they’re still around 70 basis points lower than the bond market – and the bond market has even started to price in a series of interest rate cuts, despite language from the Fed largely centered on patience. In this volatile environment, our assets selection process and hedging strategy, which considers a variety of possible future interest rate paths continued to deliver value. Specified pools materially outperformed TBA MBS. Obviously, there’s a lot more refinance risk in the market, but spec pools also benefited from the big increase between gross WAC and net coupons in the TBA, Fannie and Freddie market. The agency mortgage bases tightened throughout Q1. However, there was a meaningful divergence between owning the generic agency bases through TBAs and owning mortgage exposure in specified pool form. With rates rallying to 18-month lows and a number of the thematic points we have been making on the increasing amounts of negative convexity in the market started to result in actual prepayment changes. This is another example of the market not properly pricing in possible outcomes that are not currently in the money. Prepayment risk has been increasing for sometime. This risk accelerated, as rates start to drop. But the cost of prepayment insurance measured by spec pool pay-ups really didn’t take off until the prepayments had already arrived. In addition, the upward WAC drift across the new issue MBS pool landscape has made repayments for generic pools more responsive in a bad way to increase new financing incentives that follow a drop in mortgage rates. Meanwhile, the lack of Fed buying has removed them as the buyer of last resort for TBAs, forcing other investors to determine the ultimate market premium price for the risk. We always keep a close eye on technological innovation and policy shifted to GSE and are on the lookout for anything that can affect prepayments. Recent GSE initiatives, which have been focused on shortening loan closing times and shielding originators from rep and warranty risk continue to gain traction. These trends have been building for over a year and seemed to be gaining further momentum under the FHA new leadership, which has been largely ignored by investors, who are convinced that interest rates are much higher and that the Fed would keep hiking. Look at Slide 12. Both Fannie Mae and Freddie Mac have rolled out programs, where borrowers can get property inspection waivers, saving the cost in half of an appraisal. While this program is small, it’s a big deal for those loans that are affected and should lead to much more prepayment reactivity. While the entire specified pool sector appreciated more – far more than TBAs, those pools offering the most call protection appreciate the most. Most specified loan balance pools outperform TBAs by more than 50% on a price performance basis. Prepayments increased throughout the quarter and should continue to increase. Fannie and Freddie speeds increased 25% month-over-month from February to March. But while month-over-month changes are eye-opening, the baseline reference points in this case was low. In April, speed should continue to increase in a fairly predictable way with some slight surprise to be upside in higher coupons. Overall, prepayments for both Ginnie Mae and Fannie and Freddie sector continue to fall well within market estimates. Liquidity returned to the bond markets in the first quarter in contrast to what we saw in December. An abrupt shift from central banks across the globe prompted spread tightening and changed forward expectations of the level of interest rates. We believe that dovish tone is a boon for spread products benefiting MBS and the changes in the prepayment landscape will create a more dynamic trading environment in specified pools. We saw lots of opportunity to take advantage from dislocations this quarter and we took advantage of much higher specified pool pay-ups to sell some specified loan balance pools and rotate into lower-priced forms of call protection. We expect to see continued healthy turnover in our portfolio as the recent move-down in interest rate has led to some great relative value opportunities. We still see Agency MBS is attractively priced on both in absolute and relative basis. Even with this strong performance, MBS actually lagged investment-grade corporates spreads by a wide margin in Q1. So we think this gives Agency MBS some protection should credit spreads widen. On the policy front, we see potential changes coming that could be very advantageous for Agency MBS. We feel real possibility of Fannie and Freddie shrinking their footprint perhaps by tightening their guidelines for investor properties or larger loans. This could shift the mortgage production away from Agency loans into non-QM loans, which would reduce the new issues supplied at Agency MBS and drive strong Agency MBS performance. So with attractive yield spreads, great relative value versus corporates and a potential supply decrease if we – if the new head of FHA implements some of his suggestions, we think Agency MBS are in a great position to deliver strong performance going forward. Now back to Larry.

Thanks, Mark. In any big market move, the quality of mortgage assets is often much more important than the headline yields on those assets. And this past quarter was a great example of this. The portfolio we brought into the year was heavily concentrated in prepayment protected specified pools, which carry lower yield spreads than do the generic mortgages underlying TBA securities, and there’s no free lunch, with lower yield spreads, come lower net interest margins. However, when interest rates dropped dramatically in the first quarter, our prepayment protected pools did exactly what they were supposed to do, namely resist a duration shortening and a rally. Please turn back to Slide 9. As described in the bullet points at the bottom of the slide, our overall portfolio only dropped by 18% in duration in a quarter where 30-year mortgage rates dropped by almost 50 basis points. Meanwhile, TBA 30-year Fannie Mae 4s, as a comparable generic, shortened by 37%. So the shortening of our portfolio was only half that of TBA Fannie Mae 4s in a big rally. That’s the main reason why our specified pool pay-ups expanded so much and why EARN’s portfolio was able to achieve such a strong total return even while maintaining its full portfolio of interest rate hedges in a falling interest rate environment. So as we think about portfolio construction at EARN, there are constant trade-offs and interactions between realized volatility, book value preservation and net interest margin and core earnings. While the net interest margin is provided by Agency MBS have tightened in recent quarters, forward looking interest rate volatility is also at historically very low levels, as the market used the Fed as somewhat boxed in. As a rather technical illustration, on March 20, the move index, a measure of implied volatility across the Treasury yield curve had an all-time low of 42.5 and that goes all the way back to the index’s inception in 1988. So from a net interest margin and core earnings perspective, the entire agency mortgage REIT sector is seeing some compression, and EARN is no exception. But from a forward looking total economic return perspective, the Agency RMBS investment landscape actually looks healthy. Put another way, net interest margins have compressed, but the expected friction to net interest margin in the form of expected book value erosion has fallen just as much. So investors in the mortgage REIT space might see somewhat lower core earnings in the near future, but the opportunity to achieve attractive total economic returns remains strong. With that. we’ll now open the call to your questions. Operator, please go ahead.

[Operator Instructions] And your first question comes from Doug Harter with Credit Suisse.

Hey, guys, this is actually Josh on for Doug. Larry, following up on those comments you just made about lower – possible lower core earnings, we’ve seen some of your larger peers cut dividends in the second quarter. What are your thoughts around current dividend levels? And I guess related to that, how are you seeing leverage trending over the coming quarters, given the returns you’re seeing in the market? Thanks.

Yes. Well, for us, I don’t think that we’re necessarily going to change our strategy on leverage, which is to dial it up slightly, if we see better opportunities and down slightly if we see worse opportunities. But from a dividend perspective, I think, we’re taking a wait-and-see attitude. We – what we’ve seen with repo, borrowing costs, for example, versus three-month LIBOR, we’ll see if that persists. And we’ll see – we had a great first quarter, obviously, we’ll see how the quarters to. And we – there’s lots of things that we can do with the portfolio, portfolio turnover, et cetera, to impact our core. But we’re going to be focused a lot on total return here and seeing not just how our core is comparing to our dividend, because as I think you can see based on our presentation, we have chosen to position the portfolio in a way, where there will be less book value erosion. But we’ll see how the opportunities present themselves, if we decide we want to rotate the portfolio into higher-yielding types of assets and pools, then that would make a difference – big difference to our core. But we’re only going to do that if we think that from a total return perspective if that’s going to make sense.

Makes sense. And then just a quick modeling on. Do you guys have a number on the impact, either dollar amount or basis points from the reversal of the LIBOR repo spread, if it was material?

Yes. I mean, it’s definitely a material change to the – that’s on the slide, what slide that is on? That graph? Well, we haven’t measured it on a backward-looking basis.

Yes.

So – but you can see that where we were in the third and fourth quarter of last year and pretty much our repos have, by and large, mostly rolled off since then. Now you can see that was a big difference. So, you’re talking about something that’s certainly going to have. It looks like – continue to have like a 25 basis point differential versus where it was, and you can multiply that by our leverage and you can see that’s going to be at least a couple of 100 basis points, right, in terms of how that affects our run rate, if you will, leverage run rate. And so that’s not significant. I mean, it’s not life changing, but it’s definitely a significant change. And we’ll see – we’ll monitor that and see whether that reverses. But as I said, I don’t think at this point, we’re certainly not, at this point, seeing worse opportunities to generate total returns, and I think we’re going to stay the course at least for a while yet.

Great. Thanks for the colors, Larry.

Yep.

Your next question comes from the line of George Bahamondes with Deutsche Bank.

Hi, good morning. My question was going to be focused on leverage trends and just some of the things that EARN would need to do get to maybe bridge the gap between the core EPS run rate and the dividend. It seems like you may have just touched on that in the prior question. I don’t know if you have any additional comments there, but that was the…

Yes. [indiscernible]

Yes. So we’ll definitely continue to look at as we always do repositioning the portfolio, if we think that it makes sense to go into some higher-yielding assets. I mean, one asset class that we always take a closer look at when rates go down paradoxically is IOs. So, if we see some big increases in prepayments and that might shake up the IO market, and we would actually have no qualms about increasing a very modest position in IOs and we could increase that substantially and that would have a big impact on core. So let’s see how the prepayment landscape shakes out, and we’ll – like I said, we’re at a great point right here, where there is – could be a lot of shake ups in various sectors of the mortgage market, and we’ll try to take advantage of that. And if that allows us to reposition the portfolio into higher-yielding securities that we think are worth it, from a risk-reward perspective, we’ll do that.

Great. Just a question on leverage, and I know that there – I think it would depend on the environment. But is there a, maybe max amount of leverage that you’d be willing to take on? Would – could we see leverage go as high as 10 times of – or that is just not a scenario that you could see maybe falling into?

Hey, George, it’s Mark. I think that would probably be the max. That seems the high-end. I mean, if I look back this quarter and I see almost 6% return for the quarter, which is 24-odd-percent annualized, much more focused on the big book value. Yes, we’re also focused on the big book value again we generated, right? And if it…

Right.

…if core doesn’t quite keep up with dividend, but we’re generating the big book value increases, then I think that’s – that, I think, that’s constructive on the dividend.

Great. That’s all I have for this morning. I appreciate your time.

Yes, I think – and that’s – sorry, I just want to add. That’s consistent, I think, – I know that’s consistent with what we’ve said before in terms of leverage. Of course, on a – I think, on a short-term basis, we could always go over that, especially if the repo market from a funding perspective look healthy. But I think we really do think that, that would be a short-term measure to increase repo – I mean, leverage above 10:1, and that would be in response to a very exceptional market opportunity.

Understood. Thank you.

Our final question comes from the line of Mikhail Goberman with JMP Securities.

Good morning, gentlemen. I’m wondering if – during the first quarter, you guys saw any sort of repo pricing dislocation in the market, that led to the sort of the reversal of the funding advantage?

This is Mark. It was sort of a gradual process, right? We found a consistent repo levels throughout the quarter. We tend to avoid a lot of the quarter-end volatility. You can see, I know around year-end and it would be at the end of the first quarter. If you had to do repo borrowings right the last day, rates got expensive, but that didn’t impact us at all. And the Fed just had their meeting this week. They nudge down the rate at which they’re paying banks interest on excess reserves. We think that’s going to translate into a modest 2 to 5 basis point drop in our repo expense. So, I don’t think it’s anything that was a big sea change, I just think it was sort of incremental.

Yes. I would add one thing, Mark. Curious, if you agree with this. We noticed also that sometimes it’s correlated with the shape of the very short – very, very short end of the yield curve. So the very short end of the yield curve is steep, rise that like it used to be then for lenders to get something that’s indexed off a three-month LIBOR, you’re looking around LIBOR there, more likely to take a spread that’s three-month LIBOR and extend out a little bit on the curve. Again, we’re talking about the very short end of the curve to do that. And then as the very, very short end of the yield curve is flattened, I think that definitely was a contributor to the – to what’s happened to this relationship.

Very interesting. Thank you very much. And just a sort of my other questions have been answered, but just a ubiquitous question on appetite for buybacks at these levels of 90% a book, I believe you still have a $1 million in the authorization, is that correct?

That’s correct.

Okay.

Yes. No, I think in terms of what that would do to our – we look very closely our expense ratios, the cost benefit of repurchasing shares at this point at these prices in the low 90% of book, we – where we are, I think, as we speak, around 92% don’t – or not in favor of repurchasing at this point. So that’s been on hold. We did repurchase some at the very beginning the year, but we were trading much, much lower than that.

All right. Thank you very much, and congrats on a very good book value quarter.

Thank you.

Thank you.

There are no further questions at this time. This does conclude today’s conference. You may now disconnect your lines.