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Ellington Residential Mortgage REIT (NYSE:EARN)

Q1 2014 Earnings Conference Call

May 13, 2014 11:00 ET

Executives

Larry Penn - Chief Executive Officer

Mark Tecotzky - Co-Chief Investment Officer

Lisa Mumford - Chief Financial Officer

Analysts

Tapfuma Chibaya - Credit Suisse

Steve Delaney - JMP Securities

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT First Quarter 2014 Financial Results Conference Call. Today’s call is being recorded. At this time, all participants have been placed in a listen-only mode and the floor will be opened for your questions following the presentation. (Operator Instructions)

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

Jason Frank - Secretary

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 and can be identified by words such as believe, think, expect, anticipate, estimate, project, plan, continue, intend, should, would, could, goal, objective, will, may, seek or similar expressions or their negative forms or by reference to strategies, plans or intentions.

As described in our Annual Report on Form 10-K filed on March 21, 2014 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 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.

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

With that, I will now turn the call over to Larry.

Larry Penn - Chief Executive Officer

Thanks, Jason. It is our pleasure to speak with our shareholders this morning as we released our first quarter 2014 results. We appreciate everyone is taking the time to participate today. While in the first quarter, the bond markets were relatively calm compared to recent quarters, as usual we were quite after the Ellington Residential and we are profitable in both our agency and non-agency portfolios.

Our higher coupon agency specified pool portfolio, which we carefully built and diligently enhanced over the latter part of last year has performed very well and we think it still has a lot more upside potential. As a byproduct of our active trading style and our constant desire everyday to upgrade our portfolio, our overall net interest margin increased to 2.34% from 2.17% in year end. And as a result, we increase our quarterly dividend by 10% from $0.50 to $0.55. Looking forward, as you will hear from Mark, we feel that the market has got a little complacent here and we are committed to be ready to capitalize in any fallout should volatility resume.

We will follow the same format as we have on previous calls. 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 remainder, we have posted a first quarter earnings conference call presentation to our website www.earnreit.com. You can find it in three different places on the website; on the Homepage, on our Shareholders page or the Presentations page. 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. As a reminder, we sometimes refer to Ellington Residential via New York Stock Exchange ticker, EARN or EARN for short. Hopefully, you now have the presentation in front of you and open the Slide 4.

And with that, I am going to turn it over to Lisa.

Lisa Mumford - Chief Financial Officer

Thank you, Larry. Good morning, everyone. In the first quarter, we had net income of $2.8 million or $0.30 per share. Our net income for the quarter was composed of core earnings of $7 million or $0.77 per share, net realized and unrealized gains on real estate securities of $14.6 million, or $1.59 per share, and net realized and unrealized losses on our interest rate hedging derivatives of $18.8 million or $2.06 per share. As a reminder, we include the net periodic cost associated with our interest rate swap and the component of core earnings.

Of course, long-term interest rates dropped over the course of the quarter. So, it’s not surprising that we had gains on our assets and losses on our interest rate hedges. By contrast in the fourth quarter of 2013, we had a net loss of $124,000 or $0.01 per share and core earnings of $6.8 million or $0.74 per share. The 3.6% growth in our core earnings per share was due to a decline in our cost of funds and an increase in the yield of our assets.

With respect to our cost of funds, we have seen a decline in the cost of retail financing as old and new deals alike have displayed an increased asset type to provide leasehold backed by agency RMBS, which has increased competition among them and consequently lowered financing rates. In addition, as interest rates selling during the quarter, the cost of our interest rate swaps declined even though we extended the overall maturity of our swap book. Overall, our cost of funds declined 3 basis points to 1.14% over the quarter. Quarter-over-quarter, our average borrowed funds was roughly the same at $1.3 billion.

While interest income was relatively flat quarter-over-quarter at approximately $12 million, the average yield in our overall portfolio increased to 3.48% from 3.34% in the fourth quarter. Included in the 3.48% is a cash of premium amortization adjustments of approximately $253,000 representing 7 basis points of the 3.4%. The cash of premium amortization adjustment reflects the fact that prepayments remained low during the quarter thereby stretching out the recognition of the premium we paid to acquire our specified agency RMBS for.

In the fourth quarter, the catch up premium adjusted was approximately 11 basis points. Excluding the adjustment, the average yield on the overall portfolio increased to 3.41% during the first quarter from 3.3% – I am sorry, 3.23% during the fourth quarter and our net interest margin increased to 2.27% from 2.06% in the fourth quarter. We actively traded the portfolio within our holdings of agency RMBS as measured by sales and excluding principal pay-down. We turned over approximately 44% of the portfolio. Our non-agency portfolio is also actively managed although turnover there was relatively low for us at 17% during the first quarter. During the quarter, our average yield on our non-agency portfolio increased to 10.4% from 9%.

We ended the quarter with a total RMBS portfolio value just above $1.3 billion essentially unchanged from the fourth quarter. As I mentioned earlier, our outstanding borrowings were also little changed, but just under $1.3 billion. Our leverage ratio at the end of March was approximately 7.8:1 also unchanged from the end of fourth quarter. We declared and paid a first quarter dividend of $0.55 per share, which represents a 10% increase over our fourth quarter dividend. The increase in our quarterly dividend is related to the higher net interest margins we are capturing as compared to last year. Lastly, we ended the first quarter with shareholders equity of $165 million or $18.05 per share, a decline of 1.3% from $167.2 million or $18.29 per share at the end of the fourth quarter.

However, our economic return on book value was 1.7%, economic return adding back dividends to ending book value per share and comparing that amount to book value per share as of the beginning of this quarter.

I will now turn the presentation over to Mark.

Mark Tecotzky - Co-Chief Investment Officer

Thanks Lisa. The change in how investors have priced the agency mortgage market quarter-over-quarter was substantial. It’s not that prices moved so much, it’s the way investor view them risk versus reward changed. Towards the end of last year when 82 mortgages were so stressed, we reduced our mortgage hedges in the favor of spot based hedges and that served us well. After nearly six months of anticipation back to logistics and consequences and the federal reserves tapering on the QE3 buy program, in the first quarter of the year investors could finally see the market reactions in the taper. So, it was a collective side relief by market participants when it became clear there was more than enough demand for agency mortgages to take the place and produce Fed buying and they are still going to manifest itself in many ways.

Look at Slide 7, back in 2013, the market was fearless about interest rate volatility in a kind of a big scale like someone that Fed talked about taper. But now that we are halfway through the taper the market once again seems well concerned about rate volatility. We went to the market in the second half of last year that was the Fed’s ability to taper without closing substantial dislocations. So the market is now convinced that Fed’s (indiscernible) pass out of QE without closing any turbulence. You can see that in swaption pricing. The drop in both realized and implied volatility benefited parts of the mortgage market by RMBS priced modestly into the park were sure the most volatility.

When people talk about negative complexity of MBS they are basically talking about their exposure to short-term volatility. This has been an amazing change in reutn mix given it’s most interesting parts of QE through April yet to come that will come late summer and the net supply of agency MBS finally exceeds present purchases and private investors who have put capital into the mortgage markets as opposed to taking it out which has been the experience over the last year. For the quarter, the mortgage market was supported by three powerful or four of them. First interstate movements in the quarter were limited for the inherent negative conductivity of agency mortgages was not a drag on performance and as we saw on the slide expectations are for continued limited revenue. Two, prepayments were very low events when we do anticipate. And thirdly net new originations of the 80 mortgages were surprisingly low. For investors that both protect themselves from interest rates was a great quarter. We of course managed the portfolio to protect investments rising across the curve which obviously protects the book value tremendously last year. And now we have a market where we are able to hedge our mortgage investments with much lower yielding swaps than at the start of the year.

To show just how lower production in the mortgage market is look at the next slide, Slide 8. New pools in the mortgage market come from refi, existing home sales and new home sales. On this graph we normalized existing home sales, new home sales in the refi index all of that to January 1999 levels. All three are at or near generation of loans. So against this backdrop of low supply spread volume over the quarter has really impacted us. We expect things look modestly different next quarter with all these timetables coming up of these volumes.

On the demand side the March reduction in the Fed purchases was evened out by other participants. CMO activity remained steady. Fixed income and mutual flows turned positive after substantial outflows in the third and fourth quarter of 2013. And pension funds and insurance companies both put mortgage money to work in 2014. We are allocating similar capital out stock into bonds after the stock market fell in 2013 performance. Despite the very low levels of prepayments much of the capital product specified tools and these are straight infections that full market trades very well.

Slide 9, you see this graph of payouts on when you left liquid parts of the pool market, Fannie Mae CQ pool, which consist of certain high volatility loans originated under the making home affordable program. These pools do not qualify for deliveries into TBA contracts, they can save either above or below the comfortable TBA coupons depending on market conditions.

Last year, these pools have been creating almost 1 point over TBAs to more than 1 point below TBAs. And you could see this is just the beginning of the year, we have appreciated in price relative to TBA by almost a point. So, why is that? It’s not because of prepayment. It’s a lot of other reasons. Some of these pools have a year-to-date yield pickup versus TBAs. Some of them will start to be able to have higher turnover fee relative to TBAs. I guess the larger point is that despite lower overall interest rate volatility, we have still done some very interesting – we are putting some very interesting volatility and pay-ups that creates trading opportunities for us. And as Lisa mentioned, our agency portfolio have turned over a lot in the quarter. Pay ups performance and mortgage performance is quite strong in April and we saw book value increase of about 3% in the months.

Let’s look at another portfolio balance in the quarter. Despite trading actively, we didn’t make any real big changes in portfolio composition. As you can see on Slide 12, we increased our agency coupon by over 15 basis points. And as you can see on Slide 11, we added more adverse mortgages and initiated a position in 20-year mortgages. The portfolio size and types of prepayment stories we say didn’t evolve much. One nice thing is that we are able to both increase the average maturity of our repo and at the same time lower the average rate as we have shown on Slide 16.

Our outlook going forward is that we think the market believes that the Fed (indiscernible) QE3 may get tested sometime in Q3 or Q4, so may see some greater opportunities caused by interest rate volatility. While we expect prepayment to remain low by historical standards, we do expect to increase. From many mortgage originators, it’s a matter of survival. Their fixed costs are simply too high to be profitable as the Q1 volumes we showed on Slide 8. We think the reactions in the mortgage banking industry will be increased competition for loans, slightly lose our underwriting standards and continued industry consolidation.

Fortunately, for the industry, mortgage rates are already over 25 basis points lower than where they ended last year. And that coupled with the usual seasonal increases in the home buying activity to move to more production in Q2 and Q3 than what we saw in Q1. That increase and it is why combined with further Fed tapering too create a somewhat less supportive environment for agency CMBS which may create some fallout and leaves some great investments.

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

Larry Penn - Chief Executive Officer

Thanks Mark. As you can see, we had a solid even somewhat eventful first quarter. We stuck to our net. We enhanced our portfolios through active trading and we had certain interest rate risk in the same disciplined manner that our shareholders have come to expect. As a result, we continue to increase our net interest margin and core earnings. This led to an increase in our dividend. This past quarter was probably the first one since our IPO, where most of our residential mortgage REIT peers actually had higher absolute economic returns than us. Remember however that just about everything went light than in last quarter. Long-term interest rates declined, volatility dropped, and prepayments remained subdued.

Looking ahead, we really believe that the market may have gotten too complacent here. It is highly probable that later this year, the Federal Reserve will no longer be a net purchaser of agency RMBS. That will surely create some very different dynamics. It’s been over 1.5 years that the Fed has been dominating the agency CMBS market and the market frankly has probably gotten more used to that, realizes. People have such short memories, which is truly a paradigm shift when the Fed initiated QE3 and it’s just too early to say that the MBS landscape won’t change drastically when QE3 ends.

Meanwhile, the bond market is not as deep as it looks. The big Wall Street investment banks certainly won’t get in the way of a big move. As we saw in 2013, the large bond funds with their daily liquidity don’t dampen volatility anymore and it’s where they actually contribute to volatility as daily redemptions and the snowball following market down dress. Of course, we can’t say for sure that there will be dislocation, but we can say that if there are dislocations, we plan to capitalize on those just as we did last summer. Thanks to our disciplined hedging program and disciplined liquidity management.

One market that we are keeping a close eye on for future opportunities is the MBS derivative market, which includes IOs. As you may know IOs, which prices generally increase as interest rates rise, can be an extremely efficient tool in managing interest rate risk. A relatively small amount of IO and lower the portfolio’s risk to rising the interest rates as much as a relatively large number of loan maturity fixed interest rate swaps. And if price rise, the IOs can do this with much less track to core earnings in those most interest rates swaps.

As you can see on our portfolio summary on Slide 11, as of quarter end, we only had around $16 million market value of agency IOs. These IOs had an average duration of negative 24 years which means that they were replacing the risk of about $45 million of 10 year swap. While a number of factors within the IO market are a little pressured right now, we believe that any big rate movement whether up or down will probably calls the IO market solution up and what we ready to increase that portfolio when the time is right.

This concludes our prepared remarks. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Douglas Harter of Credit Suisse.

Tapfuma Chibaya - Credit Suisse

Hi. Thanks guys. This is actually Tapfuma for – on for Douglas Harter. Yes. Just one remark, obviously seen in the couple of quarters where your core earnings outpacing the dividend there, just wondering at what point we will start to see some convergence is that the core that you are pinning today kind of reflective of the true earnings powerful portfolio?

Larry Penn

Yes. Well, obviously that’s going vary from quarter-to-quarter we do, but you want specifically on our core earnings as opposed to regular earnings.

Tapfuma Chibaya - Credit Suisse

Correct.

Larry Penn

Right, well okay. So…

Tapfuma Chibaya - Credit Suisse

So whatever is the best metric that you guys look at for the dividend there?

Larry Penn

Right, yes. So I would say it’s a mix of both but I would say core earnings is really what we look at more weighted a little more heavily. So yes, it has core earnings has outpaced the dividend. We are trying to be conservative with the dividend. The dividend only is required by REIT world to match our taxable income. So if we can manage our taxable income in a way to keep it a little bit below the core earnings and yet at the same time have a dividend which is an attractive yield, we think that’s the best of both worlds.

Yes, the taxable income so to get ahead of ourselves then we obviously will need to increase that dividend or will pay a special dividend, but we rather not do that because we are also looking at regular earnings which is as you know for us is fully mark to market, so that sort of gets back to book value and we want to try to maintain a stable book value over time as well. So it’s a bit of balancing act. If we were just basing on our core earnings then we would be increasing the dividend, but we are now we are sort of balancing core earnings, taxable income and economic income all at the same time.

Tapfuma Chibaya - Credit Suisse

Great, that’s really helpful. And just secondly just wondering if you – what your comments are when you look at your outlook for the pay ups in the portfolio especially in light of what we saw coming out of GSC’s realizing some of the repo and warranties, maybe if you can comment on that a little bit?

Mark Tecotzky

Yes. This is Mark. You know that ‘15 we had to show that refi new home sale purchases existing home sale purchases are all at really low levels. You can look at one of those time periods only are dated back to ‘99 but the other one you have dated back to 80s or 60s. If you look at like new home sales for example those aren’t adjusted for population, those things at levels where they were in the 80s if you adjust for population, well, that’s where we were in the 60s. So I think that you are going to see some improvement on all those metrics, right. A little more refis, more of new home sales, more existing home sales which is going to cause more prepayment as well as just more turnover. So I think the combination of less that buying activity, more supply and an uptick in refi is going to be supportive for a lot of the payout stories. Some of the stories have done extremely well that one graph stories hit three change points has been end of the year and some of that was behind the strong April we had mentioned were up about 3%. But very slow a lot of these payout stories that doesn’t really have room to appreciate. So still it’s the longer time series on these things. I think there can be further gains. The other thing is that when we talk to mortgage originators, the first quarter of this year was as tough an environment as most of these people have ever seen. They have relatively high fixed cost. So, they have to get aggressive on every type of production they can and just to survive. And you are seeing that now, you are seeing a little bit of credit box and you have all these comments today from what about potential things the GSCs can do. So, clearly, I think people are concerned about the very low levels of new home sales and want to see if there is policy things that can be done that will spur some activity.

Tapfuma Chibaya - Credit Suisse

Great, thanks, guys.

Operator

(Operator Instructions) Your next question comes from the line of Steve Delaney of JMP Securities.

Steve Delaney - JMP Securities

Thank you. Good morning, everyone and congratulations on a good start to the year. Mark, you mentioned, Norwalk, we had the GSC scorecard this morning came out and the speech you gave at the Brookings Institute. I thought the most specific I guess maybe impactful point was tripling the amount of risk transferred of the private sector up to $90 billion in 2014 and we are well into the year to be tripling it versus last year. It doesn’t appear that in earn that you have participated in any of those stack or cash deals thus far? I did see there is 2.5% in other non-agency. Is any of that referencing these GSC risk transfer notes?

Mark Tecotzky

Hi, Steve. We have not participated in those deals. When we look at the pricing of those deals, we make absolute sense to us why guys like Norwalk want to increase this item. They are getting tremendous pricing on those really if you lay the stacker spreads versus the GPs are, the government is able to inflate themselves from a lot of downside on their guarantee book without giving up much of the spread they are getting on GCs. So, I think it makes a lot of sense. I just think also to its comments about not changing low limits, just seems like you are going to be with (indiscernible) changing things at the margin. So, we have not participated in those deals, because the way we look at them we think we have better opportunities in other sectors in the non-agency market.

Steve Delaney - JMP Securities

Right.

Mark Tecotzky

Of course, if an increased supply changes the pricing significantly that could change.

Steve Delaney - JMP Securities

Exactly, that’s where I was going, they have tightened tremendously and you have to put a lot of leverage to get anything close to a double-digit yield or a high single-digit, but just wondering if maybe this additional supply could create an opportunity and a nice feature of course is that they are floating rate assets?

Mark Tecotzky

No, absolutely, yes. Those things were to, you get in this location cheapen up, where you see some issues with the cash flow done in any of them that caused idiosyncratic price moves. Yes, it could definitely become an opportunity.

Steve Delaney - JMP Securities

Okay. Moving to the agency portfolio, it does seem we are in a almost in a kind of a little sweet spot or column this year in mortgages have certainly performed very well year-to-date. But I did take note to your caution that as we moved paper coming to conclusion and people start thinking about cost to carry versus what the outlook for Fed funds might be that we could get some cheapening of the basis as the summer goes on. And I am really thinking about spread widening, because you are pretty darn well hedged up. It appears from just an interest rate risk standpoint. But what specifically if you saw and you thought spreads might rollout 20 or 30 basis points, what types of things might you do to try to protect book value in that kind of scenario?

Mark Tecotzky

One is you can sell assets, right, sell assets and receive on trough, so shrink your outright spread duration mortgages. The other thing is you can sell TBAs. If you look at how we did June, July, August last year that was even if you look at bond market sell also for a long period of time, that was a very violent sell off, right.

Steve Delaney - JMP Securities

Yes.

Mark Tecotzky

And we did a good job protecting book value. So, I don’t think – I don’t anticipate that kind of volatility, but I definitely think you have seen a pattern before that a rise in rates leads to bond funds, money redemptions based outlook something Larry alluded to in his comments. Based outlook – and liquidity and capital provides these markets by the primary dealers it’s not what it used to be. So a lot of big customers sell things getting wider, things even go down to twice and there is not going have I don’t think we have primarily dealers stepping in and really be in the buffer. So we watch that very closely.

Larry Penn

Yes. We have - we have had the percentage of our interest rate hedges by duration weighted basis, that are in TBAs is that close to a third, right. So hedging that a third of our interest rate risk with being short TBAs that’s I am sure, that’s pretty high I am sure relative to the peer group, that’s actually not that high for us. We could easily drive that up to 50% or even more. So that’s really the main way I think if you for us to get into a defensive mode very quickly if that would be a very easy way to do it.

Steve Delaney - JMP Securities

That’s helpful guys. And I didn’t know you had that kind of flexibility given the REIT income test ability to go up to the 50% of your total hedges?

Larry Penn

Yes. It turns out – everyone is really comfortable and it has been several years now that a short TBA position is basically no - is as good as an interest rate swap or is as valid as an interest rate swap in terms of hedging the risk that rising interest rates will increase your borrowing costs. So because obviously if you are short TBAs you will make money and that income can used to offset your higher borrowing costs so (indiscernible). So everybody is going comfortable with that and so we take full advantage of that.

Steve Delaney - JMP Securities

And one last thing Larry – thank you for that. But one last thing, we know it’s you got a public document out there and S-11 filing from late March. One thing that we have observed in the last couple of weeks is there has been sort of resurgence and relatively small offerings of even perpetual preferred or longer term notes we call baby bonds, just curious if you have your eye on that market and if it’s possible that an instrument like that might be available to you – to just defer the timing which you might need to come to market with another common offering?

Larry Penn

Right, I mean we are not – that’s not something that we are after we are looking out right now, I think the pricing especially for some of the smaller companies that you have seen on those types of instrument has been we think pretty unattractive.

Steve Delaney - JMP Securities

You are near 8% I think?

Larry Penn

Some of the larger companies some people of course have different stock price that is 85 preferred, but some of the much larger companies have gotten more aggressive pricing even then I am not sure that it would make sense for us. But given where we borrow we are not I think we are – we don’t have just to increase our asset base per se.

Steve Delaney - JMP Securities

Yes.

Larry Penn

It’s not by issuing some sort of unsecured debt or I am sorry preferred or convert lines to make that’s not something that we feel is that importance, that’s not something that we are really looking at that closely right now.

Steve Delaney - JMP Securities

Also says but it tells me that you are, well growth is I am sure something that you would like to accomplish managing the portfolios first and foremost and if the market gives you the opportunity to raise more common and the markets attracted you will do it but you are not going to force it is am I reading you right?

Larry Penn

Yes. I mean we read up obviously what a big discounted book, so we are no where near where we can even start thinking about that and that’s okay. We have got lots of things to do here and we are patient as you know, so we will wait for the right time.

Steve Delaney - JMP Securities

Thanks for the comments. I appreciate it.

Operator

There are no further questions at this time. Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT’s first quarter 2014 financial results conference call. Please disconnect your lines at this time and have a wonderful day.

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Source: Ellington Residential Mortgage REIT's (EARN) CEO Larry Penn on Q1 2014 Results - Earnings Call Transcript

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