Ellington Residential Mortgage REIT (NYSE:EARN)
Q3 2013 Earnings Call
November 13, 2013 11:00 a.m. ET
Sara Brown – Secretary
Larry Penn – President and Chief Executive Officer
Lisa Mumford – Chief Financial Officer
Mark Tecotzky – Co-Chief Investment Officer
Douglas Harter - Credit Suisse
Trevor Cranston - JMP Securities
Jim Young - West Family Investments
Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT Third Quarter 2013 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. Please go ahead.
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, continue, intend, should, would, could, goal, objective, will, may, seek, or similar expressions by reference to strategies plans, or intentions. Forward-looking statements are subject to a variety of risks and uncertainties including those described in Exhibit 99.1 of our quarterly report on Form 10-Q filed on June 11, 2013, that could cause the company’s actual results to differ materially from its beliefs, expectations, estimates and projections. Other risks and uncertainties and factors that could cause actual results to differ materially from those projected maybe described from time to time in reports we file with the SEC. Consequently, you should not rely on these forward-looking statements as predictions of future events. Statements made during this conference call are 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 on the call with me today, Larry Penn, Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Chief Investment Officer; and Lisa Mumford our Chief Financial Officer. As a reminder, we have posted a third quarter earnings conference call presentation to our website, www.earnreit.com. You will find it right on the presentations page in the 'For Our Shareholders' section of the website. Lisa and Mark's prepared remarks will track the presentation so it will be helpful if you have this presentation in front of you and turn to Slide 4 to follow along.
While you getting that in front of you, I would just like to mention that while the full name of the company is Ellington Residential Mortgage REIT, sometimes on this call we will refer to it just as Ellington Residential, and sometimes on this call we will refer to it by its NYSE ticker, E-A-R-N or EARN. I will now turn the call over to Larry.
Thanks, Sara. It's our pleasure to speak with our shareholders this morning as we release our third quarter 2013 results. We appreciate everyone taking the time to participate on the call today. We will follow the same format as we did on the previous call. 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.
Hopefully you now have the presentation in front of you and open to Slide 4. With that I am going to turn it over to Lisa.
Thank you, Larry, and good morning everyone. In the third quarter, we earned total GAAP income of $6.8 million or $0.74 per share. Of those amounts, core earnings represented $5.6 million or $0.61 per share. GAAP earnings over and above core earnings was $1.2 million or $0.13 per share. During the second quarter we had a GAAP net loss of $9.7 million or $1.55 per share, and we had positive core earnings of $1.3 million or $0.21 per share.
During the third quarter, we recovered a significant portion of the second quarter GAAP net loss through a combination of spread capture as measured by core earnings, trading gains and asset price improvements. You will recall that while we consider ourselves substantially ramped by the end of the second quarter, during the second quarter we were not fully ramped up as our initial public offering only closed in early May.
Let's look at the components of our core earnings. During the third quarter our average yield in our portfolio increased from 2.82% in the second quarter to 3.09% in the third quarter. Mark will talk about this more in his remarks but we actively traded the portfolio. Within our holdings of agency RMBS, as measures by sales and excluding principal paydowns, we turned [ph] over almost half of the portfolio. In so doing we were able to purchase pools at prices that we haven't seen for quite some time thereby providing a nice boost to our yields.
Quarter-over-quarter our agency yields increased 33 basis points to 2.96%. On the summary portfolio tables beginning on Slide 12 of the presentation, you can also see that as of the end of the quarter the average cost of our agency portfolio declined almost 1.4 points. We believe over the course of the quarter we have the enhanced the potential return profile of the overall portfolio, both in terms of yield and types of agency pools held.
We also maintain a small non-agency portfolio. The relative size of this portfolio and the sectors that we are invested in did not change much quarter-over-quarter. But here too we actively traded the portfolio. During the quarter as measured by sales, we turned over approximately 25% of the portfolio and our book yield increased to 7.85%. In the third quarter our cost of funds including the cost of hedging with interest rate swaps, increased 13 basis points to 1.32%. The increase was related to our interest rate hedges as long-term interest rates increased over most of the quarter. Our cost of repo quarter-over-quarter remains relatively constant at 38 basis versus 37 basis points in the second quarter.
The cost was relatively flat but at the same time we extended the average term of our repo by almost 20-days and we also added two counter parties. Operating expenses including management fees were 3.2% of average shareholder's equity on an annualized basis. Based on our current capital, we expect they will be in the range of 3.2% to 3.3% of shareholder value.
We ended the quarter with a total portfolio based on market value of just under $1.5 billion, up from about $1.4 billion at the end of the second quarter. Our outstanding borrowings increased to $1.3 billion from $1.2 billion and our leverage ratio at the end of September was 7.5:1 versus 7.2:1 at the end of June. We paid a third quarter dividend of $0.50 per share and combined with our second quarter dividend year-to-date we paid $0.64 per share. We ended the quarter with shareholders equity of $171.8 million or $18.08 per share, up 1.2% from June 30. I will now turn the presentation over to Mark.
Thanks, Lisa. This is a quarter marked by both extreme interest rate volatility and extreme volatility in the relationship between the agency mortgages and the traditional rate hedging instruments as swaps and treasuries. Fannie 3.5 traded in the 4 point range but meanwhile the 5-year treasury notes only traded in the 2.5 point range. To not only preserve but actually increase book value this quarter required two things. First, in the violent sell off to early September, you had to have enough of the correct hedges in place so that book value decline was manageable and you weren't forced into large scale portfolio liquidations.
Second, you had to recognize the very compelling valuation that agency MBS reached at certain times in the quarter and you had to capture that opportunity. I think that this quarter also shows that you have to be dynamic in your portfolio positioning. One particular strategy that worked in the past won't always work in the future. You have to evaluate the market every quarter based on the current conditions.
Let's look at the current opportunity. So on Slide 7, specified pool pay-ups. For most of 2013, specified pool pay-ups have been the thorn in the side of mortgage REITs. Pay-ups have been contracting in sell off but they haven't done much at all in values, therefore have been underperforming expected interest rate performance. As a result of that underperformance, we now view them as having excellent risk reward balanced. We show this on Slide 7. Here we regress the pay-up on medium loan balanced 30-year Fannie 4s against the price of TBA or generic 30-year Fannie 4s. We conceive from the data points in the upper right, that these pools used to trigger [ph] over 140 tics over TBA. That’s almost 4.5 points.
Now the pay-up is only 0.5 point. And what's interesting is that the pay-up has stayed about 0.5 point as Fannie 4s went up in price towards the end of the quarter. Slide 8 makes the point another way. J.P. Morgan puts this together. This is generally how the world looked coming into the end of the quarter. Agency pass-through [ph] prices had retraced about 50% of their decline but specified pool pay-ups only retraced about 10% of their decline. Look at the row that we had highlighted, that was shown on the previous graph.
In the sell-off that started in early May and bottomed out in early September, Fannie 4 has been down in price 145 tics. A little over 4.5 points. Then towards the end of the quarter, they have recovered almost 2.5 points. So over 50% of their price decline. But the pay-up on this type of loan balance specified pool went from 104 tics, down to 8 tics. It has only recovered back to 16 tics. So the pay-up declined over 90% and has recovered back to only 15% of where it started in May. And that is the same dynamic for most of these coupons and categories of prepayment protection. [Indiscernible] option pool pay-ups when we sold [ph] off, very little movement back in the value.
So I think this presents a good opportunity for us. If long-term rates reverse some of their recent upward moves, we would expect pay-ups to increase relative to TBA. If the bond market sells off more, pay-ups is already so low it's hard for them to decline a lot.
Slide 10. We labeled this slide volatility is volatile. This is the graph in swaption pricing over time. Swaptions are great complements to a portfolio of long MBS hedge with fixed rate payer swap, because swaptions replace some of the volatility that agency MBS are short relative to swaps. But buying swaptions costs money that takes away capital from interest bearing assets. Swaptions also decay in price if the market doesn’t move much. Much like the first four months of this year. In that case they would lower book value. Also their prices, as you can see from this graphs, can move dramatically over time. So you need to time it well.
Buying protection of the IOs [indiscernible] is expensive. Look at the price of this swaption. Look at the price of this swaption that’s over 7.5 points and then quickly declines 15% in price. So I think you have to look at this and conclude, swaptions from time to time are great way to protect book value from large interest rate moves but timing of swaption purchases can make a big difference in performance. Same thing with IOs. They are another great instrument that help control interest rates that we also use. So my point is, that just as you have to be dynamic about how do you manage the long side of the agency MBS portfolio, you also have to be dynamic in your hedges and take advantage of a variety on instruments at your disposal.
Turning to slide 13, the agency portfolio. We grew the agency portfolio by 10% over the quarter with most of the changes in 15-year and ARMs. Last quarter was the first time in a long time we were able to buy ARMs at levels we considered effective. We will be on the lookout for more.
So moving over to Slide 17, you can see we extended the term of our repo. That’s something we will also look to continue to do. On slide 19, you can see that we increased our TBA hedge. We did that in response to mortgages recovering significantly towards the end of the quarter. So you can see that on the third line, the net exposure, pools minus TBA shorts only increased modestly. We traded very actively in the quarter not only to protect book value necessary, but also to generate excess returns created by forced deleveraging of many fixed income players. This factor created some good relative value opportunities for the company in the third quarter that we tried to catch.
With that I would like to turn the presentation back over to Larry.
Thanks, Mark. This quarter was just a great quarter for Ellington Residential in so many ways. We increased our net interest margin. We generated GAAP income enough to cover our dividend and then some. We increased book value and we increased the size of our portfolio, all at the same time. I guarantee you, there is no way we could have done all that without a very active management style and approach that we bring to the RMBS market.
Furthermore, I feel that this style and approach of ours positions us very well to take advantage of some great opportunities which I will discuss shortly. Now as you recall, the markets in May and June have been very challenging. Although we navigated those months really well, thanks to some very disciplined hedging.
To put my closing remarks from this third quarter earnings call in perspective, I would like to start by just quoting my final paragraph and my closing remarks of our second quarter earnings call. Here's what I had said. Importantly, there are a lot of silver linings here. Agency pools offer terrific value here. Prepayment and policy risk has gone down as rates have risen and meanwhile spreads are wider. In fact, we could make back more than half of that 5.5% book value decline with just a 10-basis point tightening in MBS yield spreads. Furthermore, our competition for assets is noticeably lower than it's been in a long time and we still have dry powder. So while this was a difficult quarter for us, the market move has created many opportunities going forward. We believe as strongly as ever in our approach and our strategy. We hope to continue to differentiate ourselves, not just by controlling downside and bad markets as we did in this past quarter, but by capturing upside in good markets. That’s the end of the quote.
So what actually happened in the third quarter. Our ROE for the quarter was around plus 4%, non-annualized. So we are already that close to even. With spreads wider now, we increased our net interest margin and we increased it even more with a combination of active trading and increased leverage, thanks to the dry powder that we kept. Remember, throughout all these big interest rate movement in the second and third quarter, we were never under any pressure to sell any asset. So as Mark implied earlier, at various points in the quarter the mortgage base just widened.
When weakness hit a particular sector, we were always in a position to calmly evaluate whether this was a good opportunity to make a portfolio move. Like increase the size of the portfolio or decrease the TBA hedge, or add a new sector like agency ARMs. Or rotate out of one sector into another. The volatility of this past quarter seems to have tripped off a lot of other agency MBS players. But we actually thrived on it this past quarter. In the background throughout all of this, is that there is just much less competition out there for specified pools then there used to be. And that has really worked to our advantage.
Mark also alluded to the optionality of the portfolio we have constructed. Namely, we have been able to add higher coupon prepayment protected pools at great levels. Our average pay-up is only 0.15%, like 5 tics. But it's incredible how much additional prepayment protection we have been able to purchase at that miniscule price. Mark already walked you through slide seven and eight, which was a great analysis of the attractiveness of the entry point from a technical standpoint.
To bring home the point, let's take a look at Slide 9. The 30-year mortgage rate was 3.4% at the time of our IPO in early May. Then it got as high as 4.58% towards the end of August. But by the end of October, it stood at 4.1%. So it had retraced about 40% of that May to August increase. One more 48 basis point drop like that and we will be in the middle of another mini refi boom. And then those prepayment protected pools that we bought should really spike in value as Mark discussed.
Now I realize that not many investors are positioning themselves for another big drop in rates. But the beauty of this trade is that in the meantime even if rates don’t drop, we can hedge these prepayment protected pools to a longer duration. Which means that if rates rise a lot, we can actually make money just delivering them into our TBA short positions. So this kind of portfolio construction can really help us handle big interest rate shocks either way.
This third quarter is a great example of why we at Ellington Residential love the agency pool market. The high liquidity of the agency pool market allows us to very actively manage the portfolio. The depth and breadth of the agency pool market allows us to be extremely disciplined about what kind of pools we chose to be invested in at any given time. And the complexity of the agency pool market allows us to apply Ellington's extensive experience and analytical expertise to hedge effectively and to make informed portfolio decisions.
Looking forward, we see a market where interest rates, yield spreads and pay-ups will continue to be volatile. If our strategy were just a buy and hold strategy, we might just try to ride all that volatility out. But that’s not our strategy. We are going to continue to hedge volatile interest rates in a disciplined manner. So when MBS prices overcorrect on the downside, as they so often do, we can by buying when others are selling. We are going to continue to take advantage of yield spread volatility in agency MBS by dialing up or down the extent to which we hedge with TBAs.
We are going to continue to take advantage of pay-up and sector volatility by actively rotating between specified pool sectors and adding new sectors like ARMs, when the time is right. We are going to continue to use our analytical tools and expertise to try to identify mispriced [ph] fundamental factors while at the same time using our long years of experience in these markets to appreciate and factor in the technical factors. This is an excellent environment for us.
This concludes our prepared remarks. We will now open the call for Q&A. Operator?
(Operator Instructions) Our first question comes from the line of Douglas Harter with Credit Suisse.
Douglas Harter - Credit Suisse
Thanks. Just wondering if you guys could talk about your outlook for where you agency mortgage spreads heading in the next three-six months?
Hey, Doug, it's Mark. I think that you saw in the third quarter is rates were so volatile and you got the 10-year note right up to 3% and there was clearly a lot of deleveraging, mutual fund redemptions. So I think a lot of the selling of MBS that we would have expected would a company the take [ph] the announcement from the fed, I think some significant portion of that you saw take place in the third quarter. So I think that positioning right now is more balanced than what it was.
So I would say that while we expect volatility going forward, I don’t think it's going to be of the magnitude of what we have seen. I think it's still an open question though because, you know there is a lot of ways the fed can taper, right. The magnitude by which they reduce their purchase over time I think is going to be very important. So I think there is a lot of ways they could taper which would be very damaging to the market at all, and you have a lot of big portfolio on their way to MBS already setup. And then there are ways in which they could taper, which I think could cause pressure on spreads. So I think it's still an open question. I would just say that, the positioning coming into tapering now though, I think is much more on size than what it was three-months ago.
Douglas Harter - Credit Suisse
Great. And then, obviously you guys added some ARMs. Can you talk about where you see that market today? How much of the selling pressure from other players has passed and where those spreads relative to where they might have been, say six months ago, or some frame or references where spreads are today versus the past?
Yes. You know ARMs are a fantastic, great asset. When we first started doing whole pools in the other company, in the EFC, that’s all we owned because it's fantastic asset for a REIT. And then I think what happened is that because they are also fantastic asset for a bank and as good as your REIT funds, banks funds better. So I think the competition for ARMs just got to be too fierce from the banks and it drove them to levels they weren't the most attractive asset for a REIT, at least the way we looked at things. So we reduced our holdings a lot.
Now what happened in the third quarter, there was some supply of ARMS that was coming from some portfolio sales at a time when the primary dealers weren't in the mood to really warehouse a lot of risks. So there were some big portfolio trades that took place. We were able to buy a few pieces at levels that to us looked like they were probably 60 basis points wider than where they had been. Now since then it has been a pretty material recovery in ARM spreads. I think the AOCI filters coming off for banks is going to make ARMs even more attractive to banks relative to fixed rates than they had been.
So I don’t know who the other buyers have been. I know some other REITS bought. But you have retraced at least half of the widening. So we look from, we find pieces that fit. We would like to find more. But it's not nearly as liquid a market as the fixed rate market. So I think you just have to be ready to react for them when you see levels that are attractive.
(Operator Instructions) Our next question comes from the line of Trevor Cranston with JMP Securities.
Trevor Cranston - JMP Securities
Congratulations on a nice quarter. There was a brief mention in the slide deck, I don’t think you guys talked about it much in the prepared remarks, about adding some reverse MBS pools this quarter. Can you guys maybe just expand a little bit what you see as attractive about that market and if that’s something you could see becoming a more material part of your portfolio going forward.
Yes. So this is the [indiscernible] program with reverse mortgages. And what we like about them is that they don’t have the same prepayment reaction to interest rates as the other types of agency MBS we have. So I think the returns on them are attractive. From net interest margins they look good but I also think that from a diversification standpoint, they are a great asset for us and they are not short yields. So if you think like in bond [ph] term, they are not short, as much volatility as a traditional 30-year, 15-year mortgage-backed bond is.
So you can finance them attractively. It just depends on the level where they are at relative to other agency MBS. But I could definitely see that sector growing. I think it's a -- I think the most thoughtful portfolio we can construct is going to be a portfolio that takes advantage of as many pockets of value in the agency mortgage market as we can find and we can think of an analyze and get comfortable with.
So ARMs, reverse mortgages, I think those represent great pockets of value from time to time there. So I think trying to drive the return for shareholders is important for us to get that exposure at times when we think it's going to a be a good total return.
Trevor Cranston - JMP Securities
That’s helpful. And on the dividend, obviously core earnings are a little bit higher than the dividend this quarter. Can you guys just talk a little bit about the, how you think about the policy if you expect to treat the dividend kind of similarly to how you do at EFC, where you set it at a level that can be sustained for a few quarters and then sometimes a true-up at the end of the year. Of if you would expect it to move around a bit more quarter-to-quarter with results coming.
Sure. I think we -- everyone's different, no right or wrong here. But I think we like the sort of stable dividend approach. And as you say, sort of looking out to the near and medium term to see what's sustainable. So now one thing that a REIT like our needs to be focused on is the fact that you are acquired to payout all your taxable income, right. So that’s something that will also affect the dividend although potentially only on a onetime basis, right.
But other than that I think, we are hopeful that our core earnings will continue at a nice level and that will enable us to continue to maintain a stable dividend and we have sized it at something that we think is conservatively sustainable over the near to medium term.
Our next question comes from the line of Jim Young with West Family Investments.
Jim Young - West Family Investments
Mark, you had mentioned that there are different ways that the fed could taper. Could you share with us how you think about the different scenarios and how are you with the probability where you connect this [indiscernible]?
Hey, Jim, that’s a hard question. I was just really thinking about that they have a lot of latitude and the magnitude by which they reduced their monthly purchases. You know what's interesting is that since they have been doing QE3 [ph], the huge range in monthly production of agency mortgages. You know in the March, April we were, there was a lot of refi's, right. It was 70-odd percent of the volume. So you had very big gross issuance numbers in the agency mortgage market and the fed was basically buying the $40 billion plus few investing pay-downs.
Now as we have sold off some of the big coupons, no longer refinancing the Fannie 3s, Fannie 3.5s, refi index is much lower and the gross volumes you are seeing have come down a lot. Yet the Fed hasn’t changed their purchase volume at all. So I think that given that gross volumes are pretty low right now, if they do taper, I would say, $5 billion-$10 billion a month, then they are buying what acts to be more impactful than what their buying was the first quarter of this year, because volumes are down so much. So just saying that -- you know I can't really probability weight [ph] it, but volumes are down a lot. So I could see them, if they did kind of gentle taper I think the market could perceive that as being very supportive of a lower mortgage rate. I think that’s not getting to exactly what you want, I just don’t have probabilities in my head. I just think that the fed has a lot of latitude in how they start to extricate themselves from this position of providing this extraordinary liquidity.
(Operator Instructions) At this time it appears we have no further questions. I would now like to turn the floor back over to Mr. Larry Penn for any additional or closing remarks.
Okay. Thanks everyone for participating on the call today. Enjoy the holidays and we look forward to speaking with you on next quarter.
Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT's third quarter 2013 financial results conference call. Please disconnect your lines at this time and have a wonderful day.
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