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Edited Transcript of EARN earnings conference call or presentation 5-Nov-19 4:00pm GMT

Q3 2019 Ellington Residential Mortgage REIT Earnings Call

Connecticut Nov 22, 2019 (Thomson StreetEvents) -- Edited Transcript of Ellington Residential Mortgage REIT earnings conference call or presentation Tuesday, November 5, 2019 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Christopher M. Smernoff

Ellington Residential Mortgage REIT - CFO

* Jason Frank

Ellington Residential Mortgage REIT - Corporate Counsel & Secretary

* Laurence Eric Penn

Ellington Residential Mortgage REIT - CEO, President & Trustee

* Mark Ira Tecotzky

Ellington Residential Mortgage REIT - Co-CIO

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Conference Call Participants

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* Joshua Hill Bolton

Crédit Suisse AG, Research Division - Research Analyst

* Mikhail Goberman

JMP Securities LLC, Research Division - VP & Research Analyst

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Presentation

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Operator [1]

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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. (Operator Instructions)

It is now my pleasure to turn the floor over to Jason Frank, Deputy General Counsel and Secretary. Sir, you may begin.

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Jason Frank, Ellington Residential Mortgage REIT - Corporate Counsel & Secretary [2]

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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.

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Laurence Eric Penn, Ellington Residential Mortgage REIT - CEO, President & Trustee [3]

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Thanks, Jay, and 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 our 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 reached record highs and on July 31, the Federal Reserve cut short-term interest rates by 25 basis points and announced an end to its treasury portfolio run-off 2 months early. Sentiment flipped in our August, however, and significant market volatility returned 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. The European Central Bank cut its short-term rate, its first cut since 2016, and launched a 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 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 30 increased to $12.42 from $12.40 at 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 on new investments, following the spread widening that we saw in August.

With LIBOR rates declining, we have 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.

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Christopher M. Smernoff, Ellington Residential Mortgage REIT - CFO [4]

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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 core earnings was $2.4 million or $0.19 per share compared to $2.7 million or $0.22 per share for the prior quarter. Adjusted core earnings was lower this quarter primarily as a result of lower asset yields.

Our adjusted core 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 and projected prepayments 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 rate, 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 prepayments drove the expansion of pay-ups.

Turnover in our Agency RMBS portfolio was 15% for the quarter, and we generated net realized 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 repurchased 33,706 shares at an average price of $9.87 per share, which was about a 20% discount to our June 30 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 MBS portfolio decreased to $1.39 billion as of September 30 as compared to $1.46 billion as of June 30. Our debt-to-equity ratio at the end of the third quarter adjusted for unsettled purchases and sales was 8.6:1, a decrease from 8.9:1 as of June 30.

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 a lesser extent, short positions in TBAs and U.S. Treasury securities and futures. We increased the size of our net TBA short position 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, decreased to $1.19 billion as of September 30 from $1.39 billion as of June 30. This translates to a net mortgage assets-to-equity ratio of 7.7:1 as of September 30 compared to 9:1 as of June 30.

I will now turn the presentation over to Mark.

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Mark Ira Tecotzky, Ellington Residential Mortgage REIT - Co-CIO [5]

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Thanks, Chris. EARN had a strong quarter in a market that presented a lot of potential headwinds. Prepayments were the fastest they've been in years, repo funding costs were high relative to LIBOR, interest rates were volatile with the 10-year note yields moving in the 68 basis point range and, for parts of the quarter, segments of the yield curve inverted.

While that sounds like a tough backdrop, we did well because our prepayment-protected pools came into the quarter with attractive valuations, and their prepayments continue 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 a levered MBS strategy. After a few episodic funding stresses in Q3, the Fed has been very aggressive in adding both repo capacity and excess reserves into the system.

EARN has never relied much on overnight funding, so we were at most minimally impacted by the SOFR rate spikes. Already in Q4, we have 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 3 Fed rate cuts, the yield curve is starting to steepen again.

Look at Slide 11, which shows the difference between the 30-year mortgage survey rate and 3-month 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 drove yield spreads wider. We took advantage of that opportunity by keeping our mortgage basis exposure relatively high.

Now in the fourth quarter, we're finally seeing mortgage yields 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 steeper than we were in early September, which should attract carry-conscious investors back to the market and provide us with a great total return opportunity.

As a result of very fast prepayments to be done generic TBA-like pools, our prepayment-protected specified pools significantly outperformed TBA mortgages and even performed very well versus swaps during the quarter. The fast speeds and resulting negative rolls from 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 with little or no pay-ups to TBAs. The other 80% have a pay-up, in most cases a very significant pay-up. Compare this to the 2016 refinancing wave, when even when at its peak, you still had about 40% of the pools trading your TBA prices.

The right-hand chart shows that much of the pool market is trading well over 1 point over TBA. This active specified pool market has created a lot of relative value opportunities for us because we have always focused on prepayment analysis and pool selection. This is definitely a pool picker's market with lots of interesting prepayment stories to tease out from the data and lots of opportunities now for pay-ups on 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, but I don't think we have ever discussed negative rolls, which we've been seeing recently. This phenomena is a consequence of the fast prepayments on premium-priced TBAs, combined with the relatively narrow difference between implied TBA yields and funding costs. Negative rolls arise when the cost of the monthly paydown exceeds the positive carry of the coupon over your repo cost.

For example, when a $104-priced TBA is expected to pay at 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 paydown cost can easily exceed your monthly carry on the pool. So as 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 were able to find some high-coupon prepayment-protected specified pools at low pay-ups that were paying close to 0 CPR. These positive carry pools, combined with the positive carry TBA short hedge, had as much as 7-tick positive carry per month. That's a NIM of over 250 basis points. Now 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.

You 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 balance stories have run-up in price, and we've been selling some pools at what we consider nose-bleed levels.

By the way, at the same time that we were getting paid via positive carry to hedge our 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 interest rate risk by paying fixed on medium-term swaps was also a positive carry trade because the 3-month LIBOR you received on the floating leg of the swap exceeded the coupon you paid out on the fixed leg. The more you are hedged, 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 rolls. As you know, we actively trade our portfolio and we've 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 in to 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 1, when LTV cap on fresh cash-out refis went into effect for both the FHA and VA. While 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 FHFA will incrementally reduce the footprint of Fannie and Freddie, which could reduce Agency MBS supply and cause further outperformance.

Finally, banks have already reduced their agency securitization rates, with the result being that more agency-eligible loans are now being securitized in the private label market.

Now back to Larry.

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Laurence Eric Penn, Ellington Residential Mortgage REIT - CEO, President & Trustee [6]

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Thanks, Mark. I'm pleased with EARN's performance so far this year, and I'm most 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 the 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 30, we've generated an economic return of 8.3% or 11.2% annualized.

As we move into the final quarter of the year, I like how we're positioned, 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 attractive to us right now, both relative to recent history and relative to other high-grade sectors such as investment-grade corporate bonds.

If 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 subsectors of the Agency RMBS market, including IOs, and we would expect to capitalize in the opportunities created by that divergence. We are very light on IO product right now, and we'd love to add on significant weakness if we see distressed selling in that market.

On the other hand, if interest rates were to rise substantially from here, we'll 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 in 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 pad our net interest margin by reaching for the highest-yielding pools. Those types of pools tend to be the most negatively convex. And while our portfolio follow those types of pools, it might boost our current earnings temporarily, our book value would just get slaughtered in a big interest rate move. Instead, we have concentrated our portfolio in 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 it 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 basis is currently wide, and it's bouncing around. The rolls on TBAs are often negative and pay-ups on specified pools are all over the place. As Mark said earlier, this is a pool picker's 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, if we see significant year-end selling pressure in any of our markets. For 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.

And with that, we'll now open the call to your questions. Operator, please go ahead.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question is from the line of Doug Harter with Crédit Suisse.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [2]

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This is actually Josh on for Doug. Just looking at the core earnings this quarter, and then thinking about where the dividend is set. How are you feeling about the current dividend? And also, if you could just walk us through some of the puts and takes around 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 mark in -- or market trough in core earnings of the portfolio?

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Laurence Eric Penn, Ellington Residential Mortgage REIT - CEO, President & Trustee [3]

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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 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 if the market sort of giveth, then the market taketh away, right? And so as we've had some inversion of the yield curve and now, obviously, we're seeing that reverse somewhat, we see some more steepening. We've seen repo rates, repo funding costs that were a decent spread above LIBOR. And now there, we're 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 there are 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.

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Joshua Hill Bolton, Crédit Suisse AG, Research Division - Research Analyst [4]

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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?

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Laurence Eric Penn, Ellington Residential Mortgage REIT - CEO, President & Trustee [5]

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Sure. Yes, that's not something that we give typically with much precision, absent -- 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.

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Operator [6]

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

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Mikhail Goberman, JMP Securities LLC, Research Division - VP & Research Analyst [7]

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A quick question on where you're perhaps seeing CPRs trending so far in the fourth quarter?

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Mark Ira Tecotzky, Ellington Residential Mortgage REIT - Co-CIO [8]

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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 in November, and expectations are that will be a further increase in prepayments. Some of that comes -- some of that's a function of where mortgage rates were 6 weeks ago, sort of typical lag. And also the difference in day count month-to-month, right? So the prepayment speeds are impacted by how many business days do 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 months, 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 the prepayments on our portfolio tick up, right? So yes, you have some of these rolls out here now where they're priced to a 40 or 50 CPR. So if you can find a pool that's paying 20 CPR, that's materially higher than where our portfolio normally pays, but that can have significant carry versus the roll.

So if we migrate the portfolio composition to a little bit less prepayment protection but lower pay-ups, you could see our prepayment speeds increase relative to what they've been, but they could still be lower than -- if we do a good job, they can be lower than sort of market expectations with those pools. But I think, the prepayment report, you're going to see fifth business day in November, that should represent the peak, and then you're going to see a decline from there.

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Mikhail Goberman, JMP Securities LLC, Research Division - VP & Research Analyst [9]

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Great. That makes sense. And a 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?

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Mark Ira Tecotzky, Ellington Residential Mortgage REIT - Co-CIO [10]

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Yes. So we typically roll about 1/3 of our holdings each month, and we do it for 3 months. So we typically stagger what we're doing. So that what you see on that slide, it's really a combination of sort of where 3-month LIBOR is now, but you're kind of comparing it to where we did repo over the last 3 months. So I'd say, if you just compared 3-month LIBOR to 3-month repo in Q3, we were typically doing -- our repos were typically costing us about, I think, 5 to 8 basis points more than 3-month LIBOR.

And now what we're starting to see, and this really 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 3-month LIBOR. So when you lever that, that's a pretty big advantage. So I would expect relative to LIBOR, for 2/3 of Q4, our repo -- our relative funding versus LIBOR to improve by maybe 10 basis points. But October is kind of locked in, and it was sort of similar to what Q3 was.

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Mikhail Goberman, JMP Securities LLC, Research Division - VP & Research Analyst [11]

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So about a 10 basis point improvement in November?

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Mark Ira Tecotzky, Ellington Residential Mortgage REIT - Co-CIO [12]

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

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Operator [13]

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

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Laurence Eric Penn, Ellington Residential Mortgage REIT - CEO, President & Trustee [14]

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Okay. No, it was just thanks for participating again, and we'll see you next quarter.

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Operator [15]

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