Ellington Credit Company (EARN) Q3 2019 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2019 Third 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, Deputy General 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 third quarter earnings conference call presentation is available on our website, earnreit.com. Our comments this morning will track the presentation. Please note that any references to figures in this presentation are qualified in their entirety by the end notes at the back of the presentation. With that, I will now turn the call over to Larry.

Thanks, Jay. Good morning, everyone. As always, we appreciate your time and interest in Ellington Residential. On our call today, I'll begin with an overview of the third quarter. Chris will then summarize our financial results. Next, Mark will review the performance of the residential mortgage backed securities market during the quarter, our portfolio positioning and market outlook. And finally, I'll provide some brief closing remarks and then we'll open the floor to questions. The third quarter began with a quiet July. Interest rates were range bound, U.S. equity indices reach record highs, and on July 31st, the Federal Reserve cut short term interest rates by 25 basis points and announced an end to its Treasury portfolio run off two months early. Sentiment flipped in our August, however, and significant market volatility return, as messaging from the Fed shifted hawkish, concerns over global growth intensified, and U.S. trade negotiations with China grew tense. During the month, various volatility indices surged. Domestic equities fell, interest rates plummeted, and big parts of the yield curve inverted. The Federal Reserve responded to the increased volatility by pledging more monetary stimulus, if need be. While several central banks around the globe also responded by cutting interest rates. Moving into September, volatility subsided, domestic equities recovered and U.S. Treasury yields rose. European Central Bank cut it short term rates; its first cut since 2016 and launched the quantitative easing program. Later in September, the Federal Reserve cut its short term rate again but the decision was not unanimous clouding the outlook for future reductions. I'm extremely pleased with our performance during the third quarter. Our disciplined hedging strategy and portfolio of high quality specified pools helped out Ellington Residential deliver strong earnings, despite large fluctuations in long-term interest rates, increasing prepayment rates and an inverted yield curve. As you can see on Slide 4 of the presentation, we reported net income of $0.30 per share, which exceeded our dividend of $0.28 per share. And our book value per share at September 30th, increased to $12.42 from $12.40 June 30. Opportunistic share repurchases helped boost book value and altogether our economic return for the quarter was a solid 2.4% or 10% annualized. While our adjusted core earnings declined quarter-over-quarter. We believe that the prospects to expand our net interest margin and grow core earnings are improving, as we benefit from lower repo borrowing rates and wider yield spreads and new investments following the spread widening that we saw in August. With LIBOR rates declining, we've seen our borrowing costs come down as we reset our short-term repos. We expect that our funding costs will continue to come down. And this should be a tailwind to earnings going forward. 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 7 for a summary of EARN's financial results. For the quarter ended September 30, 2019, we reported net income of $3.7 million, or $0.30 per share, compared to a net loss of $107,000 or $0.01 per share for the second quarter. Adjusted quarter earnings were $2.4 million, or $0.19 per share, compared to $2.7 million, or $0.22 per share for the prior quarter. An adjusted quarter earnings was lower this quarter primarily as a result of lower asset yields. Our adjusted quarter earnings excludes the catch up premium amortization adjustment, which was negative $1.6 million in the third quarter compared to negative $904,000 in the prior quarter. For each period declining mortgage rates cause actual on projected repayments to increase and the Catch-up Premium Amortization adjustment was negative. Despite elevated interest rate volatility, rising prepayment risk and portions of the yield curve inverting, we benefited from strong performance in our agency RMBS portfolio during the quarter. Pay-ups on our specified pools increased for the fourth consecutive quarter and along with declining interest rates generated net realized and unrealized gains on our portfolio. Similar to previous quarters, the decline in mortgage rates and associated increase in actual and projected repayments drove the expansion of payout. Turnover in our agency RMBS portfolio was 15% for the quarter and we generated net realize gains of $2.7 million. Our non-agency RMBS portfolio also performed well during the quarter, driven by strong net interest income and unrealized gains. Even though lower, medium and long-term interest rates caused losses on our hedges this past quarter, the gains on our assets exceeded those hedging losses and we - and these net gains were a nice supplement to core earnings in the quarter. Our adjusted NIM, which excludes the impact of catch-up Premium Amortization increased slightly to 81 basis points during the current quarter, as compared to 78 basis points in the prior quarter. Our cost of funds decreased by 16 basis points to 2.4%, while the adjusted weighted average yield on our portfolio decreased by 13 basis points to 3.21%. During the quarter, we repurchase 33,706 shares at an average price of $9.87 per share, which was about a 20% discount to our June 30th book value, and which provided a modest boost to our book value per share. At the end of the third quarter, our book value per share was $12.42, up $0.02 from the prior quarter. Our economic return for the quarter was 2.4%. Next, please turn to Slide 8, which shows a summary of our portfolio holdings. Our RMBS portfolio decreased to $1.39 billion as of September 30th, as compared to $1.46 billion as of June 30th. Our debt to equity ratio at the end of the third quarter adjusted for unsettled purchases and sales was 8.621, a decrease from 8.921 as of June 30th. Next, please turn to Slide 9 for details on our interest rate hedging portfolio. During the third quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps and to lesser extent short positions in TBA, and U.S. Treasury Securities and Futures. We increase the size of our net TBA short positions during the third quarter to 11.3% as compared to 7% at the end of last quarter. Although, the size of our net TBA short position remains considerably lower than it has been historically because we remain constructive on the agency mortgage basis. Turning now to Slide 10, primarily because of the larger net TBA short position, our net exposure to RMBS, which is the aggregate market value of our RMBS holdings including our net short TBA position decrease to $1.19 billion as of September 30th from $1.39 billion as of June 30th? This translates to a net mortgage assets to equity ratio of 7.7:1 as of September 30th, compared to 9:1 as a June 30th. I will now turn the presentation over to Mark.

Thanks, Chris. EARN had a strong quarter in a market that presented a lot of potential headwinds. Prepayments for the fastest they've been in years, repo funding costs were high relative to LIBOR, and interest rates were volatile, with the 10 year note yields moving into 68 basis point range. And for parts of the quarter segments of the yield curve inverted. All that sounds like a tough backdrop, we did well because our prepayment protected pools came into the quarter with attractive valuations. And the prepayments continued to be well behaved. More than any other quarter in the past few years, this was the quarter where pool selection, hedging choices and risk management made a big difference in total return. Even after our strong third quarter, we see the current market is actually much more favorable for levered MBS strategy. After a few episodic funding stresses in Q3, the Fed has been very aggressive and adding both repo capacity and excess reserves into the system. EARN has never relied much on overnight funding. So we were most minimally impacted by the softer rate spikes. Already in Q4, we've seen our repo funding improve, and we expect more improvement going forward. As we enter late fall and winter, seasonal effects should dampen prepayments and also reduce mortgage supply, which are both strong positives for mortgage performance. Additionally, after three Fed rate cuts, the yield curve is starting to steep again. Look at Slide 11, which shows the shows the different stream to 30 year mortgage survey rate and three months LIBOR. As that spread narrowed in the third quarter, many investors who own mortgages just for their current carry became sellers and that in turn grow deal spreads wider. We took advantage of that opportunity, by keeping our mortgage basis exposure relatively high. Now in the fourth quarter, we are finally seeing mortgage yield getting significantly above repo costs again. In fact, as you can see on the right side of the graph, we're now already almost 50 basis points deeper than we were in early September, which should attract carry conscious investors back to the market and provide us with the great total return opportunity. As a result of very fast prepayments, very fast prepayments to be done generic, TBA like pools are prepayment protected specified pools, significantly outperformed TBA mortgages, and even performed very well versus swaps during the quarter. The fast speeds in resulting negative rolls for many TBA coupons created a rush by investors in the specified pools. Look at Slide 12, the left hand chart shows that less than 20% of pools are currently trading us literally no pay-ups to TBAs. The other 80% have a pay-up in most cases a very significant pay-up. Compared this to the 2016 refinancing wave, even when that's at peak we still had about 40% of the pools trading our TBA prices. The right hand chart shows that much of the pool market is trading well over 1 point over TBA. This act of specified pool market has created a lot of relative value opportunities for us, because we've always focused on prepayment analysis and pool selection. This is definitely a pool pickers market, with lots of interesting prepayments stories to tease out from the data and lots of opportunities now for pay-ups in the specified pools to expand and contract in a wide band, which plays right into our strengths. Over the years, we've talked about a lot of aspects of the agency MBS market. I don't think we've ever discussed negative rolls which we've been seeing recently. This phenomenon is a consequence of the fast prepayment of premium price TBA combined with the relatively narrow difference between implied TBA yields and funding costs. Negative rolls rise when the cost of the monthly pay-down exceeds the positive carry of the coupon over your repo cost. For example, on a $104 price TBA is expected to pay a 40 CPR, you get back about 4% of your principal each month at a 4 point loss, which is a 16 basis point cost per month. That 16 basis point pay-down cost can easily exceed your monthly carry under pool. So with negative rolls, or you lose carry being long TBA, you actually make positive carry being short TBA. These negative rolls created some of the best positive carry mortgage trades we've seen in years. We're able to find some high coupon prepayment protected specified pools at low pay-ups that were paying close to zero CPR. These positive trade pools combined with the positive carry TBA short hedge had as much as seven fixed positive carry per months, that's a NIM of over 250 basis points. And these pools don't necessarily have long lasting prepayment protection, but they have short-term prepayment protection, so through the end of the year these trades can be very profitable. We now have a mortgage market where you literally see a 45 CPR differential between the slow paying and fast paying pools for the same coupon. By comparison in 2018, you could barely see a 20 CPR differential across the entire agency mortgage universe. With so many fast paying pools and so many TBA rolls currently priced to very fast prepayment assumptions; this is a great market for those willing to make a deep dive into prepayments. The trick now is to get prepayment protection without paying too much for it. Many loan bound stories have run-up in price, we've been selling some pools that what we consider nose bleed levels. By the way, at the same time that we were getting paid via positive carry hedge or interest rate risk by being short TBA mortgages, we had a similar dynamic in the interest rate swap market this past quarter. Throughout most of the quarter, hedging into state risk by paying fixed time medium term swaps was also a positive carry trade, because the three months LIBOR you received on the floating rate of the swap, exceeded the coupon you pay down on the fixed line. The more you hedge, the better your carry was. In terms of portfolio evolution this past quarter, we shrunk the portfolio a little bit and further reduced our net mortgage exposure by increasing our net TBA short to take further advantage of weak roles. As you know, we actively trade our portfolio and we sold some pools where we thought the market was overvaluing them. We still find agency mortgages very attractively priced overall, but we also think that year end balance sheet constraints may result in some attractive entry points in Q4. We still like being fully interest rate hedged. Not only should that reduce risk, but it should also generate some incremental positive carry for the portfolio, though not as much as in Q3. There are some new tailwinds for the agency mortgage market, for example, with faster prepayments, the fed is now stepping into buy in order to meet their policy limit of $20 billion a month in their portfolio reduction of agency MBS. That buying has been supportive of mortgage spreads, and that has contributed to a strong October for EARN. Another tailwind came into effect on November 1st, when LTV kept on fresh cash out refi went into effect for both the FHA and VA. What we don't see GSE reform as a near term event, we do think it is more likely than not that the FHA will increment that the FHA will incrementally reduce the footprint of Fannie and Freddie which could reduce the agency MBS supply and cause further outperformance. Finally, banks have already reduced their agency securitization rates, with results being that more agency eligible loans are now being securitized in the private label market. Now back to Larry.

Thanks Mark. I'm pleased with our performance so far this year, and I'm especially pleased with the stability of our book value this past quarter, despite the market volatility. As always, we were disciplined in our approach to hedging interest rate risk. And we not only closely watched our overall portfolio duration, but we also closely watched our exposure to potential steepening or flattening of the yield curve. This discipline again paid off in the third quarter with solid results, and year-to-date through September 30th, we generated an economic return of 8.3% or 11.2% annualized. As we move into the final quarter of the year, I like our position and I'm excited about the investment opportunities we're seeing. Wider yield spreads and lower funding costs are improving the prospects for margin expansion and core earnings growth. And mortgage valuations seem very attracted to us right now. Both relative to recent history and relative to other high grade sectors such as investment great corporate bonds. It's between now and year end, interest rates were to fall back to early September levels and the prepayment wave were to intensify in response, we would expect to see further divergence of performance between different sub sectors of the agency RMBS market, including IOs and we would expect to capitalize on the opportunities created by that divergence. We are very light on IO product right now; we'd love to add on significant weakness if we see distress selling in that market. On the other hand, if interest rates were to rise substantially from here we will be very glad that we maintain such a low overall portfolio duration, as shown on Slide 20, for example, it's especially dangerous to take duration risk in an ultra-low interest rate environment, and I believe EARN stands apart and its ability to generate solid returns, while keeping such a tight leash on portfolio duration. It's never been our policy to earn, just to pat our net interest margin by reaching for the highest yielding pools. Those types of pools tend to be the most negatively convex. And while portfolio full of those types of pools by boost our current earnings temporarily, our book value would just get slaughtered in a big interest rate move. Instead, we've concentrated our portfolio and high quality specified pools, which carry lower yields, but are much more resistant to duration drift when interest rates rise or fall, which they inevitably do. And with the yield curve, where currently is, let's face it, it can be a challenging environment from a headline, NIM and core earnings perspective. However, in return, the market is giving us an absolute abundance of total return opportunities. And so that's where we're rightfully concentrating many of our efforts. The agency mortgage space is currently wide and it's bouncing around. The rolls on TBAs are often negative, and pay up on specified pools is all over the place. As Mark said earlier, this is a pool pickers market. We are seeing lots of opportunities for active trading and price appreciation to drive our earnings as they did in the third quarter. Finally, we always want to be able to play offense not defense. We see significant year end selling pressure in any of our markets. The time being that means that we don't want to leverage too much. We want to keep our portfolio highly liquid and we want to continue to be disciplined about interest rate hedging. We believe that our smaller size is a big advantage in this type of active trading environment, as it enables us to be nimble and react quickly to reposition our portfolio in response to market distress. With that we'll now open the call to your questions. Operator, please go ahead.

[Operator Instructions] Your first question is from the line of Doug Harter with Credit Suisse.

Hey guys, this is actually Josh on for Doug. Just looking at the core earnings this quarter. And then thinking about what the dividend is. How are you feeling about the current dividend? And also if you could just walk us through some of the puts and takes on how you see core getting closer to that level. And from your comments, is it fair to say that the third quarter is feeling like maybe a market trough in core earnings of the portfolio? Thanks.

Yes, I think in terms of where the dividend is. Yes, our core earnings are not covering - have not been covering the dividend recently, but our earnings have. So I - my - our view is that there's no need to panic and cut the dividend as long as we're earning it, whether it be through core or where, as I just mentioned, this market is providing us opportunities through total return and gain opportunities. So I think that - it's the market sort of giveth, and then market taketh away, right. So as we've had some inversion of the yield curve, and now obviously, we're saying that we're somewhat, we are seeing some more steepening. We've seen repo rates; repo funding costs that were a decent spread above LIBOR and now they are we are seeing them below LIBOR. So we see a lot of tailwinds. We see a lot of ways that the trend is reversing itself in terms of NIM compression. And that leads to core earnings compression. So as long as we feel like they're good opportunities out there and that we're actually achieving those by having our total GAAP earnings exceed our dividend. We are comfortable where it is right now.

Great, that makes sense. And then just one, do you have any update on how book value is trending quarter-to-date, or through the end of October? Thank you.

Sure. Yes, that's not something that we give typically with much precision absence. I think we've done it once or twice in some unusual market conditions. But I think as Mark mentioned that October was looking like a good month and I'll just leave it at that.

And your next question is from the line of Mikhail Goberman with JMP Securities.

Good morning, gentlemen. Quick question on where you're perhaps seeing CPR is trending so far in the fourth quarter?

Sure. So the prepayment report we got on fifth business day of October. That was market wide an increase relative to September. And we're going to get another prepayment report fifth business day November. And expectations are that'll be a further increase in prepayments. Some of that comes - some that's a function of where mortgage rates were six weeks ago, so the typical lag. And also the difference in day count month-to-month, right? So our prepayment speeds are impacted by how many business days you have in the month. But it looks like the prepayment report, we get the fifth business day of November is going to be the peak for this cycle, because December, January, February are slower seasonal month. And you've also seen now an increase in mortgage rates. And that's corroborated by a drop in the refi index. Now for our portfolio specifically, if we rotate out of some very call protected pools that have had tremendous price appreciation into some pools that are shorter term prepayment protection, but tremendous carry. You could see all the prepayments on our portfolio pickup, right? So you have some of these rolls out here now, where they're priced for 40 or 50 CPR. So if you can find a pool the paying 20 CPR, that's materially higher than what our portfolio normally pays, but that can have significant carry versus the roll. So if we migrate the portfolio composition of two little bit less prepayment protection, but lower pay ups. You could see our prepayment speeds increase relative to what they've been, that they could still be lower than - if we do a good job, it can be lower than sort of market expectations of those pools. But I think the prepayment report, you're going to see this business day in November, that should represent the peak and then you're going to see a decline from there.

Great. Thank you. That makes sense. And quick question on - I think in your slide deck, you showed as of about a month ago, the repo funding disadvantage at about 30 basis points. Can you comment on where you're seeing repo funding currently and if what your expectations are for maybe for that spread to become more positive, less negative?

Yes. So we typically roll about a third of our holdings each month. And we do it for three months. So we typically stagger what we're doing. So that what you see on that slide is really a combination of sort of we are doing with LIBOR is now, but you're kind of comparing it to where we did repo over the last three months. So I'd say if you just compared three month LIBOR to three months repo in Q3, we were typically doing our - repos were typically costing us about, I think, 5 to 8 basis points more than three month LIBOR. And now we're starting to see and that's really - what didn't, there wasn't a significant difference in October. We're starting to see a material difference in November. Now we're starting to see repo rates below three months LIBOR. So when you leverage that, that's a pretty big advantage. So I would expect relative to LIBOR, the two thirds of Q4, our repo, our relative funding versus LIBOR to improve by maybe 10 basis points. But October, it's kind of locked in and it was sort of similar to what Q3 was.

So about a 10 basis point improvement in November.

I'm hoping, yes, we just had some very preliminary levels now. But the cumulative impact of everything that Fed did with, the repo facilities and buying the treasury bills is starting to have an impact.

Thank you, ladies and gentlemen, there are no further questions. I would like to turn the call back over to you sir.

Okay. Thanks for participating again, and we'll see you next quarter.

Thank you, ladies and gentlemen, for participating in today's conference call. You may now disconnect.