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Edited Transcript of EARN earnings conference call or presentation 2-Aug-19 3:00pm GMT

Q2 2019 Ellington Residential Mortgage REIT Earnings Call

Connecticut Aug 27, 2019 (Thomson StreetEvents) -- Edited Transcript of Ellington Residential Mortgage REIT earnings conference call or presentation Friday, August 2, 2019 at 3:00:00pm GMT

TEXT version of Transcript


Corporate Participants


* 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




Operator [1]


Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2019 Second Quarter Financial Results Conference Call. Today's call is being recorded. (Operator Instructions) It is now my pleasure to turn the call over to Jason Frank, Corporate Counsel and Secretary. Sir, you may begin.


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


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 second quarter earnings conference call presentation is available on our website, earnreit.com. Our comments this morning will track the presentation. Also as 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.


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


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 second 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 beginning of the second quarter continued many of the trends of the prior quarter. Dovish messaging from the Federal Reserve continued to appease the stock and bond markets. Volatility remained low, and equities in many credit assets continued to perform well. However, volatility returned to the markets in May as global trade tensions escalated. Domestic equity sold off, interest rates plummeted and the yield spreads on most fixed income assets widened.

In June, the Federal Reserve again soothed the markets and spurred a broad rally across most asset classes by strongly signaling that it would cut short-term rates in July. Domestic equity markets welcomed the message with the S&P 500 reaching a record high on June 20. Long-term U.S. Treasury yield continued their precipitous decline with the 10-year dropping below 2% for the first time since November 2016.

As you can see on Slide 3 of the presentation, not only did interest rates fall sharply during the quarter, but the inversion between short-term and medium-term interest rates amplified. The declining interest rates led to losses in our interest rate hedges and also continued to drive increases in actual and projected prepayments, which in turn, led to widening of the Agency RMBS yield spreads, as you can also see on this slide.

As Mark will discuss later, there are other particular challenges specific to the Agency RMBS market this past quarter. But despite all this, EARN was able to protect book value.

Our Agency specified pool assets rallied in price during the second quarter, but they underperformed their hedges. And as a result, we were roughly breakeven for the quarter, as you can see on Slide 4.

We reported adjusted core earnings of $0.22 per share, which was down from the prior quarter primarily due to lower yields on our assets driven by declining interest rates and financing costs that were poised to decline but had yet to do so. With LIBOR rates declining recently, we have seen our borrowing cost come down as we reset our short-term repos. We expect our funding cost to continue to come down, and this should be a tailwind to earnings going forward.

However, and similar to last quarter, our Agency repo funding rates exceeded 3-month LIBOR during the second quarter, and in fact, the spread between the 2 widened as illustrated on Slide 6. Because we received 3-month LIBOR on our interest rate swaps, this increased inversion between 3-month LIBOR and Agency repo funding cost increases our overall effective cost of funds and reduces our core earnings and net interest margin.

Declining mortgage rates and corresponding increases in actual and projected prepayment rates again boosted the value of the prepayment protection that Agency-specified pools provide relative to TBAs. Because we concentrate our long investment in specified pools, the sizable increase in specified pool pay-ups contributed to our performance for the quarter.

Finally, with our recent dividend announcement, we adjusted our annualized dividend to an approximately 9% yield on book value or $0.28 per share. We believe that this adjustment was prudent in light of current available net interest margins. But looking forward to the second half of the year, the wider yield spreads and lower funding cost we're seeing are improving our prospects for margin expansion and thereby, core earnings growth. Indeed in July, yield spreads tightened and our funding costs fell. And as a result, July was quite a strong month for EARN.

Now I'll turn the call over to our CFO, Chris Smernoff, to discuss our financial results in greater detail.


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


Thank you, Larry, and good morning, everyone. Please turn to Slide 7 for a summary of EARN's financial results.

For the quarter ended June 30, 2019, we recorded a net loss of $107,000 or $0.01 per share compared to net income of $8.9 million or $0.72 per share for the first quarter.

Adjusted core earnings was $2.7 million or $0.22 per share compared to $3.3 million or $0.27 per share for the prior quarter. The decrease in adjusted core earnings was primarily due to lower yields on our mortgage assets, which declined quarter-over-quarter as a result of falling interest rates. Our adjusted core earnings excludes the Catch-up Premium Amortization adjustment, which was negative $904,000 in the second quarter compared to negative $944,000 in the prior quarter.

For each period, declining mortgage rates caused actual and projected prepayments to increase and the Catch-up Premium Amortization adjustment was negative.

We had a small net loss for the second quarter because declining interest rates led to net realized and unrealized losses on our interest rate hedges, which, combined with operating expenses, slightly exceeded net interest income and net realized and unrealized gains on our Agency RMBS investments.

Additionally, our performance of specified pools compared to TBAs in the form of higher pay-ups per specified pool contributed to our results, and we continue to concentrate our long investments in specified pools as opposed to TBAs. The key drivers of the expansion in specified pool pay-ups were increases in actual and projected prepayments as a result of declining mortgage rates.

Average pay-ups on our specified pools increased to 1.56% as of June 30 as compared to 0.99% as of March 31. Our non-Agency RMBS portfolio also performed well during the quarter driven by strong net interest income and realized gains.

For the second quarter, our annualized operating expense ratio declined from 3.5% in the first quarter to 3.3% this quarter, which is in line with our expectations for 2019.

Turnover on our Agency RMBS portfolio was 15%, close to the 16% recorded in the prior quarter. Our net interest margin or NIM for the quarter was 55 basis points. Excluding the impact of Catch-up Premium Amortization, our adjusted NIM was 78 basis points. This compared to a NIM of 66 basis points and adjusted NIM of 91 basis points during the prior quarter.

The average yield on our portfolio decreased by 10 basis points to 3.34%, while our cost of funds increased by 3 basis points to 2.56% quarter-over-quarter. Please note that the net interest margin and adjusted net interest margin for the prior quarter have been revised downward by 17 basis points from the amounts previously disclosed. This change was a result of an upward revision to the average holdings of our Agency RMBS for the 3-month period ended March 31, 2019, due to a computational error for that period.

At the end of the second quarter, we had total equity of $154.6 million or $12.40 per share as compared to $158.2 million or $12.69 per share at the end of the prior quarter. Our economic return for the quarter was a negative 0.1%.

Next, please turn to Slide 8, which shows the summary of our portfolio holdings. Our MBS portfolio decreased slightly to $1.46 billion as of June 30 as compared to $1.49 billion as of March 31. Our debt-to-equity ratio adjusted for unsettled purchases and sales was unchanged quarter-over-quarter at 8.9:1.

Next, please turn to Slide 9 for details on our interest rate hedging portfolio. During the second quarter, our interest rate hedging portfolio consisted primarily of interest rate swaps and, to a lesser extent, TBAs and U.S. treasury securities and futures. Because we were constructive on a Agency mortgage basis, the size of our TBA short positions decreased during the second quarter to 6.9% as compared to 15.4% at the end of last quarter. This is the lowest TBA short hedging percentage that EARN has had since its IPO.

Now turning to Slide 10. Our net exposure to Agency RMBS, which is the aggregate market value of our Agency RMBS holdings, including our net short TBA position was $1.39 billion as of June 30, up from $1.34 billion in the prior quarter. This translates to a net mortgage asset to equity ratio of 9:1 at June 30 compared to 8.5:1 at March 31.

With our TBA short hedging percentage at an all-time low, this 9x net mortgage assets-to-equity ratio is the highest this ratio has ever been for us, again demonstrating our conviction at quarter end on the mortgage basis.

I would now like to turn the presentation over to Mark.


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


Thanks, Chris. Q2 was obviously a very volatile quarter, and in a period like this, performance of a levered mortgage portfolio can vary a lot based on positioning. This quarter, within the Agency mortgage market, there was a big repricing of higher coupon TBA relative to lower coupon. The results were a big repricing of specified pools relative to TBA and there was a big repricing of roll levels.

I'm very pleased with our performance given these challenges. We preserved book value and ended the quarter positioned opportunistically. That paid off last month, as Larry mentioned, EARN had a strong July.

So to quickly recap the second quarter, there was a sharp rally across the yield curve significant enough to materially increase prepayments on newer production non-call-protected pools. So when assessing how mortgage has performed for the quarter, you really have to be specific about which mortgages because there were tremendous differences in performance, between different coupons and between call-protected pools and TBA-type pools.

Look at Slide 11. On this slide, we compare the market as if -- we compare the market as it was 2 years ago in August 2017 with the market as it is now. We went back 2 years because the 5-year swap rate in August 2017 happened to be in the same place where it is now around 180. But look at what happened to TBA. They used to be 2 points higher in price. So if you now own -- so if you own TBA or pools like TBA, the price of your asset underperformed the price of (inaudible) straight hedge by 2 points between then and now.

Now look at specified pools. Here we show LLB, or low loan balance, pools at the max $85,000 loan balance. They have performed fine. The price is virtually unchanged 2 years later. Both the TBA and the specified pools earned a lot of carry, but the specified pool didn't underperform its hedge. So what can sometimes seem like a relatively subtle difference between owning one of the securities versus the other can wind up make a huge difference in price performance.

So then the question on the underperformance of TBAs becomes why did this happen? And will it keep going? As to why did it happen, I think it was a confluence of factors that were responsible.

First, the Fed is no longer buying MBS. So the market clearing prices for the worst mortgage pools are now set by profit-seeking capital, not by the Fed. In addition, the quality of TBA pools has gotten worse. So for any given TBA coupon, WACs are higher now than they were 2 years ago. So even been setting aside changes in Fed activity, TBA's quality has gotten worse and prepayments on higher coupons got faster.

The third important factor, and this is something we've spoken out before, is the improving technology in the mortgage banking industry, combined with GSE policy changes is making it incrementally faster and cheaper for borrowers to lock in and close their loans, including refi loans. And this in turn makes loan origination more profitable and less risky for lenders. So lenders can be even more aggressive on their loan terms.

These increased efficiencies come in many forms. Fannie Mae's Day 1 Certainty program, property inspection laborers, more cash out refi activity, et cetera. The rise of non-bank lenders also amplified the impact of the new technologies as these firms tend to be more focus on automation.

Lastly, the rollout of Fannie Mae and Freddie Mac of the UMBS -- of the unified mortgage-backed security, or UMBS, has further weakened cheapest to deliver pools and that has turned -- and that in turn has lowered rolls and for many coupons.

Now for the will it keep going question on the underperformance of TBAs. Some of these changes are here to stay and should continue to pressure CPRs. In particular, efforts by the GSEs to streamline and automate the mortgage process have been well received by both lenders and borrowers. Borrowers get a quicker, less burdensome underwriting prices -- process, and lenders save money and get significant rep and warranty relief.

We think that these changes are -- will disproportionately impact generic pools but the market has already largely priced in these changes. So while we always saw some value in having a TBA short and we're always big proponents of specified pools, the relative value difference in our mind is less clear-cut now following the dramatic repricing of specified pools versus TBA.

Also, we think that Agency MBS in general, look pretty good especially relative to corporate bonds. Corporate bond spreads, both investment-grade and high-yield are extremely tight.

Also, it seems that support for Agency MBS from overseas investors has increased this year. That makes perfect sense given how low sovereign yields are in the rest of the world. For example, 10-year German bunds are around negative 45 basis points yield and 10-year Japanese JTBs are around negative 15 basis points yield. So Agency MBS with yields around 2.8% are definitely an attractive, liquid, safe investment for a global investor even after overlaying a currency hedge. And if you really focus on full selection like we do, you can find materially higher yields.

Let's now look at how our portfolio evolved over the quarter. On Slide 14, you can see that we shrank the portfolio a little. We sold some 30 years, added 15 years in reverse mortgages.

Given that Agency MBS have performed so well so far in Q3, we are now looking more closely at Agency multifamily CMBS, and expect to add some of these securities as a way to preserve spread and reduce exposure to prepayment risk.

On Slide 15, you can see that we hold most of our loan balance specified pools and many other forms of call protection. Recently though, our incremental purchases have been concentrated in pools that have more nuanced forms of call protection at significantly lower pay-ups than loan balance pools.

Now turning to policy changes. We think it's more likely than not FHA head Mark Calabria will do something to shrink the footprint of the GSEs either through LLPA adjustments or changes in g-fees.

The headlines last week were about the expiration about the QM patch at the end of 2020. While we think it highly unlikely that all of the $180-plus billion of QM patch originations flows away from Fannie and Freddie, we do think there are enough signs to conclude that the share of the U.S. mortgage market that is guaranteed by Fannie and Freddie will go down in the next few years. That kind of drop in Agency supply could be a very bullish technical for Agency MBS.

Even with the strong performance in July, we see some important tailwinds that are still taking shape. Firstly, Agency repo borrowing rates have already come down relative to 3-month LIBOR and the Fed rate cut should help even further.

Second, on the prepayment front. We think that some of the most reactive borrowers have already taken advantage of lower rates so that in combination with seasonal factors, should bring some prepayment relief in the fall. That's not to say there isn't significant prepayment risk in the market. There is and prepayment technology will continue to improve.

The post-financial crisis years of wet blanket prepayment speeds are likely over for good. But there are lots of trading and relative value opportunities for those that really dig into loan-level data and origination trends. That has been and will continue to be our focus going forward.

Now back to Larry.


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


Thanks, Mark. We have constructed our portfolio to generate steady core earnings but also to protect book value. In a market that has recently been characterized by declining interest rates and rising prepayment risk, for us, this has meant owning lower-yielding but higher-quality specified pools who so far have been much more resistant to duration shortening as compared to the higher-yielding generic mortgages underlying TBA securities.

Of course, concentrating in lower-yielding pools and hedging interest rate risk has meant a sacrifice in core earnings in the short term, but we value the stability that our portfolio has provided in contrast to portfolios that had bet on dollar rolls remaining special, CPRs remaining low and our interest rates remaining range-bound. These kinds of portfolios have massively underperformed in recent months.

We think it's a mistake to chase headline yields in any market and particularly in an environment like this. We also think it's a mistake to overleverage especially in a market like this one.

It seems that for the remainder of the year, the Agency mortgage REIT market will be dealing with low interest rates and a flat and sometimes inverted yield curve, which should continue to put pressure on industry core earnings, but we think that the opportunity remains strong to achieve attractive total economic returns in this market.

The Federal Reserve just cut interest rates on Wednesday, and there's a real possibility that more rate cuts are coming. Even with mortgage rates where they are today, nearly half of all Agency mortgages are currently refinanceable. And if rates drop further, the mortgage market could find itself in a bona fide prepayment wave.

Even if interest rates remain at today's levels, we expect to see big discrepancies in prepayment behavior between different subsectors of the Agency RMBS market, and we believe that will create excellent opportunities for us.

This is the first environment in over a decade where the market faces dramatic increases in prepayment rates without the support of the Federal Reserve as a buyer of last resort.

Without the Fed to artificially prop up prices on large segments of the Agency RMBS market, we see more dislocations on the horizon.

Our smaller size should be a big advantage as it should enable us to be nimble and react quickly to reposition the portfolio response to any market distress. We're especially hopeful the dislocations will materialize in prepayment-sensitive sectors that favor our modeling expertise such as premium coupons and IOs and inverse IOs.

As you can see on Slide 14, our portfolio is extremely light on IOs now. So we are well positioned to grow that portfolio.

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

All right. It seems we have no questions. Thank you all for participating today, and we'll see you next quarter.


Operator [7]


This concludes today's conference call. You may now disconnect.