Ellington Residential Mortgage REIT's CEO Discusses Q2 2013 Results - Earnings Call Transcript

| About: Ellington Residential (EARN)

Ellington Residential Mortgage REIT (NYSE:EARN)

Q2 2013 Earnings Conference Call

August 15, 2013 / 11:00 a.m. ET


Sara Brown – Corporate Counsel

Larry Penn – CEO and President

Lisa Mumford – CFO

Mark Tecotzky – Co-Chief Investment Officer


Douglas Harter – Credit Suisse

Steve DeLaney – JMP Securities


Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT Second Quarter 2013 Financial Results Conference Call. Today’s call is being recorded. At this time, all participants have been placed in listen-only mode and the floor will be open for your questions following the presentation. (Operator Instructions).

It is now my pleasure to turn the floor over to, Sara Brown, Secretary. You may begin.

Sara Brown

Before we start, I would like to remind everyone that certain statements made during this conference call, including statements concerning future strategies, intentions and plans 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 and can be identified by words such as belief, expect, anticipate, estimate, project, plan, should, or similar expressions or by reference to strategies plans, or intentions.

As described in Exhibit 99.1 of our quarter report on Form 10-K, filed on June 11, 2013, forward-looking statements are subject to a variety of risks and uncertainties that could cause the Company’s actual result differ from its belief, 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 statement, whether as a result of new information, future events or otherwise.

Okay. I have with me today on the call, Larry Penn, Chief Executive Officer of Ellington Financial; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford our Chief Financial Officer.

Larry Penn

Thanks, Sara. It's our pleasure to speak with our shareholders this morning, as we release our first quarter 2013 results. We appreciate your taking the time to participate today; on this, Ellington Residential Mortgage REIT's first earnings call.

The sequence for today's call will be as follows. First, Lisa will run through our financial results. Then, Mark will discuss how the residential mortgage-backed securities market performed over the course of the quarter, how we positioned our RMBS portfolio, and what our market outlook is. Finally, I will follow with some additional remarks before opening the floor to questions.

As a reminder, we posted a second quarter earnings conference call to our website, www.earnreit.com. That's earnreit.com. You will find it right on the presentations page and for our shareholders section of the website.

Lisa and Mark's prepared remarks will track the presentation. So, it would be helpful, if you could have this presentation in front of you, and turn to page four to follow along.

While you're getting them in front of you, I just like to mention that while the full name of the Company is Ellington Residential Mortgage REIT, sometimes in this call, we'll refer to it as just as Ellington Residential, and sometimes on the call we'll refer to it by its New York Stock Exchange ticker EARN or just EARN.

Hopefully, you now have the presentation in front of you, and open to page four. And with that, I'm going to turn it over to Lisa

Lisa Mumford

Thank you, Larry. Good morning, everyone.

For the second quarter, as you can see on the presentation, we recorded a net loss of $9.7 million or $1.55 per share. The net loss is comprised of the following components; net interest income and net realized and unrealized gains on derivatives of $40.5 million, offset by net realized and unrealized losses on our RMBS securities of $48.8 million and expenses of $1.4 million.

Income from our hedges offset approximately 75%f our net realized and unrealized gains on RMBS asset.

We ended the quarter with book value per share of $18.57, as compared to $19.65 at the end of March, representing a decline of 5.5%.

As you know, we completed our initial public offering in May, along with the concurrent private placement. The IPO and the private placement resulted in net proceeds of $148.5 million. We ended the quarter with total shareholder's equity of $170 million.

Some with other mortgage REIT – many other mortgage REITS, we will report core earnings each quarter. Core earnings is a non-GAAP metric and represents our net income, less the impact of realized and unrealized losses on our RMBS assets and derivates. Core earnings does include the impacts of the net periodic expense that we incur for our interest rates swap. For GAAP, this cost is included as a component of realized and unrealized gains and losses on derivatives.

On that basis, our core earnings for the quarter was $1.3 million or $0.21 per share. Our reconciliation of net income to core earnings appears on slide 22 of the presentation.

Our net interest margin for the quarter was 1.63%, which is derived from the weighted average yield on our assets over the quarter of 2.82%, less our weighted average borrowing cost, including our interest rate swap of 1.19%.

As of the end of the quarter, our net interest margin was essentially the same. We expect our expense ratio on an annualized basis will approximate 3.3%.

We ended the quarter with $1.35 billion in RMBS Holdings, $1.3 billion in agency RMBS, and just under $40 million in non-agency RMBS.

As of June 30th, our agencies are comprised of fixed rate mortgages, predominantly 30-year securities underlying fixed rate mortgages.

We had a repo borrowings outstanding of $1.216 billion at the end of June. And even though we technically didn't finance any of our non-agency holdings, based on our internal measurement of risk capital and liquidity at the end of June, about 85% of our capital was in support of our agency strategy and 15 of four are non-agency strategy.

In terms of our hedges, as of the end of the quarter, we had interest rates swap with TBAs outstanding, and you can see this on page 18 of the presentation. Our interest swaps had a notional value of $781 million, and our net TBAs had a net short notional value of $346 million.

We've been using longer data interest rates swaps, which has been much more effective hedges than shorter data swaps in the current client. Our short TBAs are obviously helpful in hedging basis risks, in addition to interest rate risks, and an important component of our hedging strategy.

We declared the second quarter dividend of $0.40 per share with the paying in July. This dividend was based on our estimate of core earnings at the time, and was based on a partially ramped portfolio.

By the end of the second quarter however, we consider the portfolio to be fully ramped. I will now turn the presentation over to Mark.

Mark Tecotzky

Thanks, Lisa. So on slide 7, at this point in the mortgage REIT earnings cycle, there's been a lot of information about the underperformance of the agency MBS in the quarter through the posted just summarizing that had to show pictorially some of the challenges since we launched in early May, and I'll talk about how we try to mitigate the risk.

This slide shows the price performance of 30-year Fannie 3s, 30-year Fannie 3.5s, the three-year treasury and the 10-year treasury. I've normalized all these prices to a 100 until the day EARN went public.

You can see Fannie 3s in the 10-year notes to two lines at the bottom of the page or each down by 8%. But nearly may Fannie 3s traded over well a $4 price and the mark we're treating them with a five to six-year duration. While meanwhile, the 10-year note had about nine year of the duration.

So, that's 8% downward moving to 10-year note should have implied about 4% to 5% downward moving Fannie 3s for them to be down 8% with the material underperformance.

Now, look at the top – now, look at the line on top. This is the price change of the three-year notes. And there's a weak – it's very tempting to hedge a lot of your interest rate risk in the front end because rates are much lower there that was a support of a higher NIM but the three-year notes had almost no hedging value because it's been largely anchored by the feds.

Shortly, after we went public, the feds essentially reintroduced interest rate uncertainty back into the market, so it's critical to head across the yield curve in a way that (massed your) assets, as opposed to being tempted to just concentrate your hedges in the front end of the curve.

We also on this slide the Fannie 3s asset; a similar phase. They've got 6%.

In early May, they had less than half the duration of the ten-year notes but they dropped 75% as much.

Part of what was going on is that the rates increased, prepayment expectations slowed. And as prepayment expectations slowed, these bonds extended in duration. And when the bonds extend out, they extend in a very steep yield curve. And the value of the yield curve between three and seven years, there's 30 to 40 basis point increase in yield for each one year of this offer.

Now, look at slide 8. This slide shows how many duration we've gone from Fannie 3.5s since May 1st. Basically, it's from four-year security to almost seven-year security.

Let's put this in perspective. On the day of EARN's IPO, the four-year swap rate was 60 basis points. By the end of the quarter, the seven-year swap rate was 215 basis points. So, on note part of the swap curve moved 100 basis points.

You can see the hedging cost of Fannie 3.5s could have increased by 155 basis points so our MBS are a lot wider than spread terms and in particular in what we call option adjusted spread, the (inaudible) price performance will translate dollar per dollar into higher NIM because some of the price declines were not at all related to yield spread widening. Instead, some was durations extending on the steep curve.

So, what are the main ways you can mitigate that risk?

Dynamic hedging, TBA shorts, and options. I think the big mistake to fit with the static portfolio and not manage over the cycles.

So, what's the good news? There's dramatically less extension risk in the market than there used to be. And for a REIT, mitigating the risk was critical in the corner – corridor.

Dynamic hedging. That meant adjusting your hedges as the market is moving, not after it's moved.

Prudent use of TBA shorts. Short positions in TBAs automatically extend in duration in the sell-off up into the control of the rate risk.

And last, what we did to control book value decline was to gradually increase our MBA exposure, keep a healthy NIM of TBA shorts and dynamically change our interest rate hedges draft to core.

Slide 9, prepayment risk. People haven't been talking a lot about this but I think it's a really big deal and I mean the quality of the NIM now much stronger than a few months ago for many true fronts, prepayment risk is completely off the table for at least a 50-basis-point move, and we can now, by a much bigger range of coupon, without having to pay more payments for call protection on specified pool.

In the day one, the amount of pool is great prepayment protection is lower than a pool that's lousy prepayment protection. So, just know that NIM isn't enough.

Today, the NIM you are able to generate can be robust for a broad range of great moves without having to take a lot of pay-up risk, and pool are a big pay-up tend to be less liquid.

To be able to – by quality pools at low pay-ups is one very favorable aspect to the market right now.

As you can see from this graph that the refi index that's plummeted, the other consequence of this is that origination volume is way down, so there are a lot fewer pools that originate at selling into the market.

Let's look at the portfolio, slide 11. So, this is where we are. What we look (inaudible). We are, in some ways, and some ways, there's a lot to be done. As we start ramping up the portfolio and the market start selling loss, we had a view that pay-ups could come down, so we bought some pools that are very modest pay-up to TBAs and expectation is pay-up drops, we would sell those initial purchases and rotate into pools, with more favorable attributes. We have been working on that portfolio. Rotation remains ongoing. We have mostly been getting more involved in both the 15-year market and adjustable rate mortgages, which are starting to look more interesting to us.

Slide 12. Here's some more steps in the portfolio.

At pay-ups for loan balance drops since our IPO, we have been buying more of them.

On the slide 13, so here's a non-agency portfolio. It's mostly all a jumble of products. We've had preference for some lower dollar price securities, we can get the benefit from improving housing market.

Now, on slide 15, the borrowing.

So, over time, we expect our counterparty – we'll be expecting to increase our counterparties and probably increase our dates of maturities.

Slide 16, interest rate hedges.

Two things to note here. We have the core TBA and mortgage hedge, although the market's been volatile, and we have seen aggressive mortgage sum on some invested leverage.

Another important take-away and Larry mentioned it is that we have a lot of our rate hedges on the longer part of the curve.

With that, I would like to turn the call back over to Larry.

Larry Penn

Thanks, Mark. As many of you already know, we brought Ellington Residential Mortgage REIT to market because we believe that there are and always will be excellent long-term opportunity in the residential mortgage-backed securities market.

Most of you know, that we already manage another public company, Ellington Financial, we sometimes refer to by its ticker; EFC.

Amidst our first earnings call for Ellington Residential, to clear up some possible confusion, I just wanted to start by highlighting the two main difference between Ellington Residential and EFC.

First, EFC is not a REIT or rather a publicly traded partnership, and Ellington Residential is, of course, a REIT.

Second, while EFC deploys most of its capital, in mortgage and asset-backed credit-focused strategies, Ellington Residential deploys most of its capital in agency RMBS and with Fannie Mae, Freddie Mac and Ginnie Mae's mortgage pools.

So, the risk of being overly simplistic, Ellington Residential is almost the flipside of EFS, as far as where to deploy the capital.

Now, when we brought Ellington Residential to market, we knew that the REIT model is one that continues for a good reason; to be very popular with investors.

In addition, the agency MBS market, which other than the US treasury market is the deepest and most liquid US fixing sector is always something the investors have a basic understanding of and long history and comfort with.

Now, while the REIT model and poses some constraints in portfolio management in general, and on hedging in particular, the constraints aren't to burn some one-offs in the case on going to residential. Since they are an agency RMBS focused REIT, the primary risk we'd need to manage its interest rate risk, and the REIT model actually allows robust interest rate risk management.

Ellington Residential objective is to deliver attractive dividend yields over market cycles, while mitigating risks, especially interest risk, and all in the form of an agency-focused mortgage REIT.

The agency pool market is one of those ideal market combinations of high liquidity agency pools frayed with a bit off our spread of just a couple of 30 seconds and high complexity. Just look at all the different flavors of specified pools out there. Each one with its unique and highly complex prepayment characteristic, not only involving interest rates, but involving geography, loan balance, loans of value, vital credit score, et cetera, give a slice on all the different types of pools that we invested in.

This makes it a great market for us. The liquidity of the market allows us to very actively manage the portfolio. The depth and breadth of this market allows us to be extremely disciplined about just what kind of pool we choose to be invested in at any given time. And the complexity of this market allows us to apply Ellington's extensive expertise in prepayment and interest modeling and analysis.

So, while Ellington Residential's goal is to form over a market's vitals, little did we know and we priced our idea on May 1st that we're about to face the toughest two-month period for agency mortgage REITs, since the down of the 2008 to the 2009 financial crisis.

Now, we're not happy to say the least that we've lost money for our investors so far but Mark Tecotzky and his team actually did a superb job, under extremely difficult market conditions keeping our book value decline to just 5.5%.

Although, Ellington Residential was less than two weeks old when all this started, it, of course, was able to leverage management's decades of experience trading these securities. Management has been talking for years about the importance of hedging over the entire yield curve, as opposed to just hedging, say, the short end of the yield curve.

But the importance of hedging dynamically as interest rates move, and about the importance of being able to hedge agency pools with short TBA positions, and being able to dial that short TBA exposure up and down, depending on market conditions.

Management's views and experience were put to the test right out of the blocks for Ellington Residential, but we just stop to our core principles and remained extremely disciplined about each of these things hedging across the entire yield curve, rebalancing our hedges with each of these rates, dialing up and down the short TBA exposure.

And as a result of this discipline, we were never any pressure to sell any asset.

When you look at what happened to the book values of other agency mortgage REITS during the quarter, and which, by the way, for those other REITS, including or – it's actually a pretty strong April for agency pools, many of these REITS was in 10% 50% or more book in value. I'm sure you'll agree that our performance actually sets up extremely well.

And importantly, there are lots of silver linings here. Agency pools offer terrific value here. Prepayment and policy risks have gone down, as rates increase them, and meanwhile spreads are actually wider. In fact, we could make back more than half of that 5.5% book value loss with just a 10 basis point tightening in MBS yield spreads.

Furthermore, our competition for assets is noticeably lower now that it's been in a long time and we still have dry powder.

So, all this was a difficult quarter for us, the market move has created many opportunities going forward. We believe a strong endeavor in our approach and our strategy.

We hope to continue to differentiate ourselves, not just by controlling downside and bad markets as we did this past quarter, by tapering upside and the good markets that will inevitably come.

This concludes our prepared remarks. Before I open the call up for Q&A, I would just like to point out that we'll be happy to assign the questions the extend to the directive to matters related either significant to Ellington Residential, more generally to the RMBS market, in which it operate.

We will not be responding to questions on Ellington's prior fund or other activity. Operator?

Question-and-Answer Session


The floor is now open for questions. (Operator Instructions).

Thank you. Our first question comes from the line of Douglas Harter with Credit Suisse.

Douglas Harter – Credit Suisse

Thanks. Any prepared remarks you referenced having some dry powder. Could you maybe expand upon that and see – let us know where you'd feel comfortable taking leverage on this type of environment? Or thank you.

Larry Penn

Sure. Yes. I'd rather not quantify in actual dollar terms but I think in a normal end market environment with sort of our typical mix of, let's say, where we are now, roughly 85% of our capital deployed in agency and 15% on non-agency. No, I think we'll be comfortable taking that leverage closer to, let's say, a little under 8 times on an average basis for now it's 7.2. So, maybe a little more than another half to turn the leverage.

I think one of the reasons that we have kept a slightly lower leverage now that we originally had thought we would was twofold.

Number one, just to, you know, recognize the fact that this is a very volatile market and it's just more prudent to keep your cash balances a little higher.

And then second, just the fact that in a market environment like that, some great opportunities could all of a sudden come along and you wanted to have the flexibility to better pounce on that. But longer term, I could see ourselves increasing that half a churn or so.

Douglas Harter – Credit Suisse

Thanks. And then, can you talk about where you're comfortable running your net duration right now or your sort of book value at risk to rises in rates?

Larry Penn

I mean we don't – in terms of having an outright duration bed, that's something we just try to avoid.

I mean our edge, if you will, is not – or testing where rates are going but other things.

So we will allow ourselves to be short something – so that's not to say that we don't have great interest rates but we try to stay pretty close at home. I'd say we try to stay less than a year in duration or about a year in duration, no more than that, as far as just what the outright duration of portfolio is.

Douglas Harter – Credit Suisse

Great. Thank you.


Our next question comes from the line of Steve DeLaney with JMP Securities.

Steve DeLaney – JMP Securities

Good morning, everyone. Thanks for taking my question, and Larry I think just before I ask my question, I like to note you priced your IPO on May 1, the Fannie Mae 3.5 was 106.6. I think pretty much a recent high and closed June 30 at 101.5.

So, in that context I think down 5% of (NASDAQ:BV) was pretty darn good, so congrats to your team.

Wanted to ask we're going to start modeling your book value now, based on the (6.30) portfolio and hedge information. I guess the question is sort of general.

You look to be pretty well hedged up. I mean if we look at swaps to net MBS, it's about 82% and I think we're probably REIT – even though we're just looking at notional, we're probably close to being somewhat duration matched up there.

Do you feel that the portfolio you had at (6.30) versus where we sit today in mid-August, did you have the portfolio pretty much where you wanted it from a risk standpoint? And if you could answer that first.

And then secondly, I know you mentioned in the press release to adding securities. I – could you comment on the securities you've added versus hedges. Is the construct to the portfolio are reasonably similar today as what we had in June?

Larry Penn

Well, I mean – so let me say that from a hedging perspective. We do try to say, as I said, close to home from a duration perspective. We do mix the TBA versus the interest rate swap. That's something that we'll change dynamically over time, so I don't want to lead people to believe that what you see at June 30 is not necessarily what we'll have. And a point over that, these are very liquid markets, and we can maneuver those – make those maneuvers quickly and sometimes you need to you know...

Steve DeLaney – JMP Securities


Larry Penn

Roll, expand and collapse the relative value of mortgages versus swap changes. So, that's something that moves a lot.

In terms of the asset side of portfolio, we have been in the middle of a rotation. And so, what – so what I would say if you look at that pie chart in terms of on June 30, which types of specified pools we were in...

Steve DeLaney – JMP Securities


Larry Penn

Again, this is a liquid market. And as we've been mentioning, a lot of the prepayment protection stories have gone a lot better, and especially where you need the most, which is in the higher coupons, in terms of – gotten better in terms of where they're priced. You can buy them very cheap without, so Mark, you want to add anything to that?

I – can't. It's too much detail but I will tell you that that – those are the themes that have been going on since June 30.

Mark Tecotzky


Steve DeLaney – JMP Securities

I understand. And I – go ahead, Mark, please.

Mark Tecotzky

Thanks, Steve. I would just add that there are a lot of types of pools that used to trade-up repoints over TBA.

Steve DeLaney – JMP Securities


Mark Tecotzky

You know basically all this year until you know June, and we'd have a bias against those things because – that and quite will past is very hard to hedge, and it's – mixed indirectly with – now, one of the stuff – stuff that yield – pools that used to trade (1.5) that can get up six picks. Pools that used to get at 3 points, you can get up 5, 8s of a point.

So, yes. I mentioned in my comments we've bought some sort of like – most like play for the pools when we started.

Steve DeLaney – JMP Securities


Mark Tecotzky

Because we thought pay-ups could come down, if the market starts selling off. So, we've been selling out of those and buying the pools that have pay-ups that's gone from 3 points to 3.25 and a point because I think – the fed definitely introduced rate uncertainty into the market with their comments since we started EARN.

I think things can go both ways, right? Like there are a lot of things that have been prices though rates can never drop, and maybe that will happen. But you can get this insurance so cheap now that I think it makes sense to do it.

Steve DeLaney – JMP Securities


Mark Tecotzky

So, does that then there's been...


Steve DeLaney – JMP Securities

Yes. That's helpful then. That's where I was going, Mark. I mean you were – in your – your 80% speck pools but within that you were 50-50 between loan balance and harp and just looking at the data we have tracking pay-ups, I'm a little surprised that it looks like to me that the harp pools, the CQs are a lot cheaper than the loan balance pools, so is that – are you seeing that as well?

Mark Tecotzky

Yes. So, those CQs – you know they have a different duration profile.

Larry Penn

Do you want to go ahead and find out those are?

Mark Tecotzky

Yes. So, for – others call it the CQs or pools they have an initial LPV to 105, 125. But as opposed to loan balance, they're not deliverable into TBA.

So because of that they have a longer duration than a loan balance pool, which you might not see on the model but that's how today in the market because the model doesn't go back to TBA foot.

And yes we have exposure to CQs and CQs have been extremely volatile.

You know we will – I wouldn't go full bore into CQs because that extra duration they have in the sell-off, you need to hedge for it right? And the extra duration on the swap curve – it's expense to hedge. You've got to be getting at least another 20 basis points in the CQs I think. So, yes...

Steve DeLaney – JMP Securities

Got you.


Mark Tecotzky

And I agree with you. They definitely gotten cheap.

Steve DeLaney – JMP Securities

And by contrast, you're saying the loan balance pools – are they generally deliverable in the TBA market?

Mark Tecotzky

Yes. They're all deliverable. So...

Steve DeLaney – JMP Securities

Okay. That helps. That helps the difference.

Mark Tecotzky

Well, they...

Steve DeLaney – JMP Securities

Well, thanks for the time and the comments.


(Operator Instructions). Our next question comes from the line of Jim Young with West Family Investors. Jim, your line is open.

That question has been withdrawn.

Our next question comes from the line of (Charles Himo with Point Capital Management).

Unidentified Speaker

Hey, Mark, I was going to just ask I think in your presentation you talked about how you initially are willing to pay a bit of a premium for paper. But generally, is the target to try to limit your prepayment risk by keeping the average cost to your portfolio addable at par?

Mark Tecotzky

No. I wouldn't say that. We look at a range of coupons – 30 years, 15 years and the hybrid space and just try to find we think is the best attributes that's going to give the best total return, the best net interest margin.

So, the discount securities, that's – those are the ones that for the brunt of its selling in the second quarter. So, those securities probably cheap enough all the way to where we're going to look at things a little bit more than some of the higher coupons.

But we look across the curve. And so, when you're in the discount securities, you're almost – it's almost like standing on your head. There are times you look at securities, you think they're going to – you look they're going to prepay a little bit faster, which helps your yields and it shorten your duration a little bit.

But to Larry's point, I think it's a good one that there is such a rich range of opportunity in loan balance, harp, credit score, geography stories, pools at 107, pools at 95. You can really try to hunt around and pick what's going to have the best long-term returns, and that's what we try to do.

So, the market is dynamic and we try to be dynamic in response to that.

Unidentified Speaker

Thank you.

Mark Tecotzky

You're welcome.


That was our final question, and I'd like to turn the floor back over to Larry Penn for any additional or closing remark.

Larry Penn

Okay. No, just thank you, everyone for participating on – this is our first earnings call today, and enjoy the rest of your summer, and we look forward to speaking with you all next quarter.


Ladies and gentlemen, this conclude Ellington Residential Mortgage REIT's second quarter 2013 financial results conference call. Please, disconnect your lines at this time and have a wonderful day.

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