Ellington Credit Company (EARN) Q4 2019 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2019 Fourth 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, Deputy General Counsel and Secretary Sir, you may begin.

Thank you, and welcome to Ellington Residential's Fourth Quarter 2019 Earnings Conference Call. Before we begin, 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 otherwise -- 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 fourth 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, and good morning, everyone. We appreciate your time and interest in Ellington Residential. On our call today, I'll begin with an overview of the fourth quarter. Next, Chris will summarize our financial results. And then, Mark will review the performance of the Agency RMBS market during the quarter, our portfolio positioning and our market outlook. And finally, I'll provide some brief closing remarks before we open the floor to questions.Accommodative monetary policy continued globally in the fourth quarter with a third rate cut from the Federal Reserve, the European Central Bank restarting asset purchases and additional policy support in China. Domestic equity indexes set new record highs and overall market volatility was low, with the VIX hitting its low point for the year in November and the 10-year U.S. treasury yield confined to a relatively narrow 41 basis point range during the quarter.Yield spreads in most fixed income sectors tightened during the quarter, particularly in December. Interest rates drifted up, slowing prepayments in November and December. And the yield curve steepened modestly going into year-end, which you can see on Slide 3 of the deck. All of these factors provided substantial support for Agency MBS. And indeed, during the fourth quarter, the Agency MBS sector posted its largest excess return relative to U.S. treasuries in more than 3 years.To capitalize on the value that we had seen in the agency mortgage basis coming into the quarter, we deliberately maintained a relatively low level of TBA short positions in our hedging portfolio. And so we were well positioned to benefit from the strong performance of Agency MBS in the fourth quarter.As you can see on Slide 4, Ellington Residential generated net income of $0.78 per share for the quarter, generated an economic return of 6.2% and grew book value considerably quarter-over-quarter. We had strong performance from both our long holdings as well as our interest rate hedges as medium- and long-term interest rates rose quarter-over-quarter.Core earnings increased $0.04 sequentially to $0.23 per share in the fourth quarter, while core earnings continue -- sorry. And while core earnings continues to run below our dividend rate, we believe that the prospects for expanding net interest margin and growing core earnings remain strong.With LIBOR rates declining and repo spreads tightening, our borrowing costs continue to fall as we reset our short-term repos, and asset yields remain attractive.Please note that for the sake of simplicity and focus, we are now presenting only one measure of core earnings rather than 2.I'll now pass it over to Chris to describe this particular change and to review our financial results for the quarter. Chris?

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, 2019, we reported net income of $9.7 million or $0.78 per share and core earnings of $2.8 million or $0.23 per share. These compared to net income of $3.7 million or $0.30 per share and core earnings of $2.4 million or $0.19 per share for the third quarter. Our strong net income resulted from excellent performance from both our long portfolio and interest rate hedges.You can see here on Slide 6 that in addition to the carry on the portfolio, we generated $9.4 million in net realized and unrealized gains on our RMBS and hedges, while our core earnings improvement was driven by lower borrowing costs, reflecting both lower LIBOR and tighter repo spreads, which more than offset lower asset yields.As Larry mentioned, starting this quarter, we will be presenting only one core earnings metric. As part of this decision, we have modified our definition and calculation of core earnings to exclude the effect of the catch-up premium amortization adjustment. This new definition of core earnings merely matches the definition of what we previously presented as adjusted core earnings, and so we will no longer present adjusted core earnings.As a result, starting with Q4 and going forward, you should compare core earnings against adjusted core earnings for prior periods. These changes are intended to help investors focus on what we believe is the more useful supplemental non-GAAP financial measure when measuring and evaluating our operating performance and when comparing our operating performance to that of our peers. Similarly, net interest margin or NIM for the fourth quarter of 2019 and for future periods should be compared against adjusted net interest margin as presented in earlier periods.A reconciliation of our core earnings to our GAAP net income can be found on Slide 25, where you can see that our catch-up premium amortization adjustment, which is excluded from core earnings and NIM, was negative $2.5 million in the fourth quarter compared to negative $1.6 million in the third quarter.During the fourth quarter, actual and implied volatility was low. Specified pools performed well, and Agency RMBS yield spreads tightened as prepayment rates declined in November and December. In addition, even though medium- and long-term interest rates rose quarter-over-quarter, pay-ups on our specified pools increased. Typically, pay-ups will weaken compared to TBAs in an increasing interest rate environment because they reflect the incremental prepayment protection that specified pools provide, but that didn't happen in the fourth quarter. Average pay-ups on our specified pools increased to 2.05% as of December 31 from 1.86% as of September 30.Finally, the quarter-over-quarter increase in medium- and long-term interest rates generated significant net realized and unrealized gains on our interest rate hedges. Also on Slide 6, you can see that our net interest margin for the quarter was 1%. The average yield on our portfolio declined 8 basis points to 3.13%, while our cost of funds decreased 27 basis points to 2.13%, driven by declining LIBOR and tightening repo spreads. Notably, repo rates were steady at year-end, which indicated that efforts by the Federal Reserve to stabilize that market were successful.At the end of the fourth quarter, our book value per share was $12.91, up $0.49 from the prior quarter. Our economic return for the quarter was 6.2%. Next, please turn to Slide 7, which shows the summary of our portfolio holdings as of December 31, 2019. Our RMBS portfolio increased slightly to $1.402 billion as of December 31 as compared to $1.395 billion as of September 30. Turnover in our Agency RMBS portfolio was 5% for the quarter as compared to 15% in the prior quarter. Our debt-to-equity ratio at the end of the fourth quarter adjusted for unsettled purchases and sales was 8.1:1, a decrease from 8.6:1 as of September 30.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 TBAs and U.S. treasury futures. TBA short positions represented 13.6% of our hedging portfolio at the end of the fourth quarter as compared to 11.3% at the end of the prior quarter.Turning to Slide 9. You can see that our net long exposure to RMBS increased slightly, so did our equity. And as a result, our net mortgage assets to equity ratio declined slightly to 7.6:1 from 7.7:1.I will now turn the presentation over to Mark.

Thanks, Chris. I'm very pleased with the EARN's performance during the fourth quarter and for the full year. For 2019, EARN had an economic return that substantially exceeded the performance of a generic-levered MBS mortgage portfolio, but without exposing shareholders to directional interest rate risk. To prove my point, note that the Bloomberg Barclays MBS Total Return Index had an excess return over treasuries of only 60 basis points for the year. With 7 to 8 turns of leverage, that implies returns between 6% and 7%. In contrast, EARN's economic return was more than double that at 14.6%.In the fourth quarter alone, we had an economic return over 6%. As in previous years, our returns were driven by superior security selection and a thoughtful and dynamic hedging strategy that's designed to protect book value from drawdowns caused by rising interest rate rates or volatility, while simultaneously putting us in position to take advantage of market dislocations. We entered the year with a 10-year note at 2.68%, and the Fed saying we were a long way from neutral. And we ended the year three easings later with the 10-year note at 1.92%, with the Fed seemingly content to sit on their hands for a long time. The sharp drop in interest rates and bouts of volatility necessitated dynamic hedge adjustments, which we see as a primary strength of ours.Prepayment risk made a similar U-turn. The refi index started the year below 1,000 and climbed to 2,700 by the summer. Prepayment protection went from being an afterthought to a must-have. And as a result, the pay-ups of our specified pools quickly repriced substantially higher. While the path of rates was unpredictable, the relative value opportunities were tremendous. EARN was able to avoid landmines and deliver solid performance. Many of the themes that we have discussed at length in previous years wound up defining the market dynamics in 2019, which I'll get into now. First, prepayments went from the wet blanket environment of the past couple of years to a full-fledged refi wave in 2019. Lower mortgage rates were the obvious driver, but technological changes from the GSEs such as Fannie Mae's Day 1 Certainty program also contributed significantly to prepayment speeds. A recognition of the implications of these technological changes played a big part in driving our portfolio positioning.Look at Slide 18, we kept our prepayment protection in place even when it wasn't popular. For the entire year and even at the beginning of the year when the refi index was below 1,000, we recognized that prepayment protection was consistently undervalued. And if rates were to rally enough, prepayment speeds would shoot up and so would the value of call protection, which would reprice even higher than it had in years past.Turn to Slide 10. This shows the 30-year mortgage rate during the second halves of 2016 and 2019. For 2016, the 3-month moving average troughed at 3.45%, while in 2019 it only got as low as 3.62%, more than 15 basis points higher. But now turn to Slide 11, and let's compare the speeds in these two periods. Here, we are comparing the worst to deliver 30-year Fannie Mae 4 in each period, which are the kind of pools you'd expect to get delivered from a TBA contract.While despite higher mortgage rates in 2019 than 2016, prepayment fees were actually significantly faster in 2019. As a result, the pay-up differential between specified pools and TBAs skyrocketed. Another consequence of these speeds was that the dollar roll levels plummeted. Since dollar rolls are generally priced that are cheapest to deliver or essentially the worst pools. We predicted this prepayment behavior based on the improvements in technology in the mortgage market. And accordingly, we positioned ourselves short dollar rolls via our net short TBA position, which was a great way to control interest rate risk.Another core view we had that really helped our Q4 results was that coming into the quarter, mortgage spreads looked pretty good on an absolute basis, but they looked very good on a relative basis. Investment-grade and high-yield corporate bond spreads had tightened dramatically during the year, far outperforming agency MBS.We held the strong view that if long-term interest rates marched higher in Q4 and prepayment risk subsided, mortgages would outperform treasuries and swaps. That's exactly what happened in Q4. Many of our holdings actually went up in price during the quarter, even though interest rates climbed and current coupon MBS prices dropped during the quarter.You can see this on Slide 6. We had gains on both our RMBS and gains on our interest rate hedges. So the yield spread tightening on our mortgages more than offset the interest rate increases. As Chris mentioned, pay-ups on our specified pools actually increased during an increase in long-term interest rates. And this shows just how undervalued our pay-ups were coming into the quarter.So given Q4 performance, how do things look now? Mortgages look pretty good, but not as attractive as at the start of Q4. The nearly 30 basis point drop in 30-year mortgage rates we have seen so far in 2020 has caused the refi index to perk back up, so prepayment risk is clearly back in play and the seasonal downturn in speeds will soon swing to a seasonal upturn in speeds.Repo financing terms have improved materially from Q4, and we think that these improved financing terms are here to stay because they are a result of systemic actions by the Fed designed to keep repo rates tracking the Fed funds rate. We think this could add 5 to 10 basis points on a nominal net interest margin to agency mortgages so as much as 80 basis points of return on a levered basis. Relative value opportunities abound, we are focused on delivering meaningful returns to our shareholders in 2020.Now back to Larry.

Thanks, Mark. I'm extremely pleased with Ellington Residential's performance in 2019. Slide 5 lists some of the highlights. Thanks to our disciplined interest rate hedging and active portfolio management, we successfully navigated a surge in prepayment rates and several periods of volatility during the year and delivered an economic return of 14.6%. Remember, we did that while keeping our interest rate duration very low throughout the entire year, so we believe that this was not only a high return, but an extremely high-quality return.Looking forward to 2020, I really like how we're positioned, and I'm excited about the investment opportunities we're seeing. Lower funding costs are improving our prospects for margin expansion and core earnings growth. And despite tightening in Q4, yield spreads are still attractive relative to hedging instruments, and they look especially attractive on a historical basis relative to investment-grade corporate bonds. But our portfolio was not only fundamentally attractive, it's also extremely liquid. This is especially important given where interest rates currently are.The 30-year treasury yield is flirting with all-time lows as is the 30-year mortgage rate. The MBA refinancing index just hit a 6-plus year high. Keeping our portfolio liquid is a conscious choice we've made at Ellington Residential, precisely so that we have the potential to take advantage of extraordinary market opportunities such as could be presented in an extreme refinancing wave. For example, we are very light on IO product right now, and we'd love to add on significant weakness if we were to see the stress prepayment driven selling in that market.In summary, in 2019, we again demonstrated our ability to generate strong and steady returns in a diversity of market environments, including periods of volatility and of stability, rising and falling interest rates and widening and tightening yield spreads.In 2020, we see a market environment that we believe plays to our strengths, where pool selection, hedging choices and risk management will continue to drive performance. And with our highly liquid portfolio and strong balance sheet, we remain flexible and able to adapt to changing market conditions, and our smaller size allows us to act quickly.And with that, we'll now open the call to your questions. Operator?

[Operator Instructions]. And your first question is from Doug Harter of Crédit Suisse.

I guess as you look at kind of the market moves that we've seen so far in the first quarter, I guess, where do you see the relative value in kind of the coupon stack? And given where pay-ups are, kind of how do you view the relative attractiveness of specified pools versus kind of more generic collateral?

Doug, it's Mark. So we still like specified pools. But I guess within the universe of specified pools, what we like more now are some of the lower pay-up stories, so we're not as big a fan of some of these things that are trading up 3, 4, 5 points from TBA. We have a big research effort here, and we've been very focused on a lot of pools where maybe the pay-ups are somewhere between 0.25 point to 1.5 points, but given our analysis of the data, we think, offer pretty material prepayment protection.So we still definitely prefer paying something over TBA to control the quality and the attributes of what we're buying, but we've rotated a little bit from the more popular prepayment stories, primarily loan balance into some of the other stories where we've analyzed the data, and it looks like these lower pay-up stories are undervalued.

Great. And I guess, relative -- on the coupons, it seems like in the first quarter, there's been more divergence in terms of coupon performance. I guess, how are you thinking about relative attractiveness there?

Yes. Some of that gets a little bit into the specifics of portfolio positioning that we normally don't go into on the call. But I guess, I would say that we're seeing certainly some attractive opportunities in 15-year space, which wasn't an area that was attracting a lot of our pool dollars last year. But I would say across the curve, it really changes a lot day-to-day that you have seen pretty big repricings within a week or within a two week period of time. So we kind of have a consistent framework where we look at the prepaid protection, and we look at where the cash flows are versus swaps or treasury hedges and see what that translates into a levered NIM. So we've been -- we cast a wide net, right? And so we bought things anywhere from 2.5s and 3s up to 5s in the past few months, and we've seen value in all of them.

Your next question is from Mikhail Goberman of JMP Securities.

I was wondering if you gentlemen could maybe give an update on where you're seeing prepays thus far in the first half of the first quarter and along maybe with an update on book value?

I'll pass to Mark on prepays. Book value will -- we can talk generally about what's happened in the mortgage basis, but I wouldn't want to go into any more detail than that. But go ahead, Mark.

Yes. In terms of prepayment, so the prepayment report that we got the fifth business day of February, that showed, as expected, a decline in prepayment speeds from the peak, but you're starting to get -- that was really reflective of higher mortgage rates than where we are now. Larry mentioned in his script that the last print of the mortgage index -- and given that that's a weekly time series and you can have -- make adjustments for day count and stuff that can be volatile. But the last print in the refi index was -- it jumped up substantially, right? And that's really reflective of sort of the current mortgage rates.So I think you've had this slower speeds so far in the prepayment report that was received by the markets at fifth business day at January and also slower speed than what we had at the end of '19 in the prepayment report that came out the first week of February. We expect the prepayment report that comes out first week of March still won't show a big uptick in speeds. When you get to the April report, we think you're going to see faster speeds than what we're in right now. And that will really be reflective of the lower mortgage rates that are in the market right now.

Okay. And one question on operating expenses. I noticed you had a very nice quarter in terms of improvement in the expense ratio from about, say, 3.5% of average equity to maybe 3.25%. Is there more appetite to drive that ratio downwards maybe into the two handle range? Or how much room do you guys have?

Yes. Obviously, that was welcome. And the -- that downtick was just thanks to some slightly lower professional fees. But in all candor, at the current capital -- at our current capital base, I don't see much potential for trimming that below -- that G&A expense ratio below 3%. But look, I mean, this is not an S&P 500 index fund, where you're going to compare companies based on -- based largely on those expense ratios. We'd love it to be a little bit lower. But if you look at all the different decisions that we're making, how we position the portfolio during the month, I mean, there's a huge divergence in the industry in terms of returns. We think that our small size, obviously, one con on that is a higher G&A expense ratio, slightly higher, but we think that we make up for it in the nimbleness of the company to react to changes in the market.And we think that in the long run, given our -- what we think is a unique strategy of keeping interest rate duration so low. I mean, I think we're unique in the extent to which we do that. And also our, at times, very heavy use of TBA short positions, obviously, we were not as heavy in TBAs in the fourth quarter. But that's something, if you look back to 2018 and earlier years, we were, at times, very heavy in that sector. So these are things that I think differentiate EARN from a lot of the other companies in the space, and I think will make a big difference and will eventually lead to outperformance over market cycles.We're not going to be -- as we've sort of said before, when there is a tailwind in the mortgage market, we're not going to be the highest performing company in the space. But at 14.6% last year, that certainly is an excellent return. And we think that over market cycles, we'll have much less volatility and a greater total return in the long run. So yes. So I don't see much improvement from where we are now, but I think there's a lot of countervailing benefits as well.

Thank you. This does conclude our Q&A session for today. We thank you for your participation. Please disconnect your lines at this time, and have a wonderful day.