Ellington Residential Mortgage REIT's (EARN) CEO Larry Penn on Q2 2014 Results - Earnings Call Transcript

Aug.12.14 | About: Ellington Residential (EARN)

Ellington Residential Mortgage REIT (NYSE:EARN)

Q2 2014 Earnings Conference Call

August 12, 2014 11:00 AM ET

Executives

Lindsey Tragler – VP, IR

Larry Penn – President and CEO

Lisa Mumford – CFO

Mark Tecotzky – Co-Chief Investment Officer

Analysts

Trevor Cranston – JMP Securities LLC

Jim Young – West Family Investments

Operator

Good morning, ladies and gentlemen. Thank you for standing by and welcome to the Ellington Residential Mortgage REIT Second 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 open for your questions following the presentation. (Operator instructions)

It is now my pleasure to turn the floor over to Lindsey Tragler [ph], Vice President of Investor Relations. You may begin.

Lindsey Tragler

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 and can be identified by words such as believe, expect, anticipate, estimate, project, plan, continue, intend, hope, 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 under item 1A of 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 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.

I have with me today on the call, Larry Penn, Chief Executive Officer of Ellington Residential; 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

Thanks, Lindsey. Once again, it’s our pleasure to speak with our shareholders this morning as we release our second quarter results. As always, we appreciate your taking the time to participate on the call today.

First, a few highlights. We earned $11.1 million or $1.21 per share on a fully mark-to-market basis in the second quarter. We maintained our $0.55 dividend which equates to a yield of 11.8% based on our June 30th book value or a yield of more than 13% based on yesterday’s closing price.

For the first half of 2014, earnings per share totaled $1.51, exceeding our $1.10 in dividends paid by a comfortable margin. In our agency portfolio, our holdings of higher coupon specified tools continue to perform well during the second quarter. And as usual, we actively traded our agency portfolio to further enhance its composition and generate trading process with 30% turnover during the quarter. Our non-agency portfolio contributed positively to our results, benefiting from tightening spreads and strong demand for higher yield and fixed income products.

Looking forward as you’ll hear from Mark, we’ve seen some positive developments in the market already in the third quarter, especially as the Federal Reserve continues to phase out its quantitative using program.

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 described in our earnings press release, we have posted a second quarter earnings conference call presentation to our website, www.earnreit.com. You can find it in three different places in the website – on the homepage, on the For Our Shareholders page or on the Presentations page. Lisa and Mark’s prepared remarks will track the presentation, so it would be helpful if you have this presentation in front of you and turn to Slide 4 to follow along.

As a reminder, during this call, we’ll sometimes refer to Ellington Residential via New York Stock Exchange ticker, E-A-R-N or EARN for short. Hopefully, you now have the presentation in front of you and open Page 4. And with that, I’m going to turn it over to Lisa.

Lisa Mumford

Thank you, Larry. Good morning, everyone. In the second quarter, we generated net income of $11.1 million or $1.21 per share. Our net income for the quarter was composed of core earnings of $6.8 million or $0.75 per share, net realized and unrealized gains on mortgage-backed securities of $25.8 million or $2.82 per share, and net realized and unrealized losses on our interest rate hedging derivatives excluding that portion which is related to the net periodic cost associated with our interest rate swaps of $21.5 million or $2.36 per share.

In the first quarter, our core earnings was $7 million or $0.77 per share and our net income was $2.8 million or $0.30 per share. The decline of $0.02 per share on our core earnings was mainly due to a drop in interest income. In the second quarter, interest income related to cash of premium amortization was negligible, whereas last quarter it was approximately $300,000 or $0.03 per share.

As a result, our weighted average for full-year yield declined five basis points to 3.43%. However, while our net interest expense was flat quarter-over-quarter, our cost of funds declined four basis points to 1.1%, plus our net interest margins dropped by one basis point to 2.33%.

Notwithstanding the media speculation about the potentially declining availability of repo financing, we continue to find it to be readily available with both long standing and newer counterparties. Thanks to increased competition among dealers, we are continuing to see a decline in our borrowing cost.

I mentioned a minute ago that our cost of funds fell four basis points during the quarter. This drop was in part driven by a two-basis point decline in our average repo financing rate to 0.33% with the remainder resulting from a two-basis point decline in interest expense relating to our interest rate swap.

The size of our portfolio didn’t change much quarter-over-quarter but we did turn over approximately 30% of our agency RMBS holdings as measured by sales and excluding principal pay-downs.

Turnover in our non-agency portfolio was less at only 6% for the quarter. While both portfolios benefit from active management, the degree of turnover can vary from period to period. Weighted average book yield on our non-agency holdings actually increased to 10.6% from 10.4% as actual and projected cash flow on the portfolio increased.

We ended the quarter with a total RMBS portfolio valued at $1.34 billion, up slightly from the first quarter. Our outstanding borrowings were essentially unchanged but as our equity increased quarter-over-quarter, our debt-to-equity ratio declined from 7.8 to 1 to 7.5 to 1.

As Larry mentioned, we declared and paid a second quarter dividend of $0.55 per share, unchanged from our first quarter dividend. We estimate that our year-to-date taxable income is slightly ahead of our year-to-date dividend.

Lastly, if you look, the second quarter shareholders’ equity was $171 million or $18.71 per share, an increase of 3.70% from $165 million or $18.05 per share at the end of the first quarter. Our economic return on book value for the quarter was 6.7%.

And with that, I’ll turn the presentation over to Mark.

Mark Tecotzky

Thanks, Lisa. Agency mortgage strategies had a few important tailwinds this quarter. First, interest rate volatility was low and interest rates gradually declined, inducing some cash to hedge along the sidelines back into the mortgage market. Prepayments were low, manageable and reasonably predictable. After several months of benign prepayments, investors began pricing in the expectation of these low prepayment volatility levels into the mortgage market hoping to support asset prices.

Most importantly, supply of newly originated pools was low in absolute terms and much lower than market expectations. And against the backdrop of very limited supply, Fed purchases, even though they were on a declining trajectory, were still impactful.

In this environment, our interest rate hedge strategy still generated significant returns. Across fixed income markets, liquidity has been declining. While the decline in liquidity is a challenge, it also brings trading opportunities that benefit our active style. Our non-annualized turnover was 30% this quarter, because of some many market inefficiencies in this pricing that our active strategy may able us to capitalize on.

Even though general prepayment levels have recently been low, looking more closely at the June and July prepayment reports, there have been a few coupons in production vintages that have actually been prepaying faster than expectations. Because the TBA market is the cheapest to deliver market, the fastest paying cohort has the potential to depress TBA pricing even for a coupon with many slow-paying pools.

In many coupons, this dynamic has been masked by the Fed’s complete indifference to prepayment speed on their investments. By looking at coupons that the Fed no longer purchases, you can get a glimpse of how pricing may evolve as the Fed’s impact on the market continues to decline.

If you look at Slide 7, you can see that TBA rolls are trending lower. Fed purchases are less than half of what they were at the start of the year. There are some coupons like 4.5 that the Fed doesn’t buy at all anymore. Fannie 4.5 is the dark blue line. The Fed no longer buys them.

The Fed’s previous purchases in 4.5 which took so many of the less desirable pools out of the market have certainly helped the quality of the remaining tradable flow in the coupon. But as some bigger balance, high cycle, lower PB [ph] pools are created with unfavorable prepayment characteristics and now have to find a home with an investor other than the Fed, the roll cheapens up. And this roll cheapening has a ripple effect.

Let’s look at Slide 8. This is an example of the ripple effect. It’s a regression of the monthly value of the Fannie 4.5 roll versus the pay-up on low loan balance pools. The lower the roll goes, the more incentive there is to buy the specified pools. The rolls can be pushed down by a relatively small amount of the outstanding balance of the coupons.

This can be fairly dramatic. These pay-ups in ticks went from low 30s to low 50s. And this can keep going. So far, prepayment speed has generally been very well contained. Last year, these pay-ups rolls were 150 ticks. So now with less Fed buying, some other investor has to be the buyer of the most prepayment sensitive slice of the mortgage production. But those other investors are generally much more concerned than the Fed about negative convexity and prepayment risk.

So this is how the ripple effect works. The Fed stops buying or buys less of the coupons. As usual, there are always new pools originated with unfavorable prepayment attributes but the Fed doesn’t buy these pools now, so these pools empty the tradable float of the coupon. As this subset of pools are the cheapest to deliver pools with the most unfavorable characteristics that fit the TBA pricing roll, this becomes the benchmark against which specified pools are compared and many of which is because their slow prepayment speed, the specified pools offer better month to month carry [ph] than rolls of the generic TBA.

This is a gradual process but it’s been noticeably happening in 4.5 and we’ll begin to see it in other coupons over time. This is why the length of time that the Fed reinvests pay-downs after it finished tapering is so critical and is a big source of uncertainty for the RMBS market.

The Fed has not given clear direction on this. Even after the Fed is done tapering, for the previous time that they are still reinvesting their pay-downs, they keep many of the worst newly printed pools out of the flow. The importance of the Fed isn’t only the amounts they buy, but also the fact that they aren’t buying exactly the kinds of pools that most – that they are buying exactly the kinds of pools that most other investors don’t want and could, absence their buying, be the marginal pool for determining TBA prices in roll levels.

Mortgage has obviously performed well this quarter. But even with that performance, adjusted for current levels of implied volatility and prepayment risk, they still look like they offer good relative value to investment grade corporate.

In Slide 9, we show the OAS to Fannie 3.5 which is the blue line with its y-axis scale on the left. And the maroon line is the OAS to the intermediate corporate bonds in the Barclays U.S. Aggregate Bond Index with its y-axis on the right. The tightness of corporate credit is one of the main reasons why mortgages have attracted so much capital this year.

Given that Fannie and Freddie are on a conservative shift, the major difference between agency RMBS and treasuries is the implicit call option in RMBS. Meanwhile, the main differences between agency RMBS and corporate bonds are the call options in the RMBS and the credit risk in the corporate bond.

The value of the call option is a function of two factors. First, how volatile will interest rates be? In other words, how likely is it that the option you were short will get in [ph] the money. And second, if the option gets in the money, how efficiently will it be exercised.

Well, for the first two quarters of this year, interest rate volatility was low and prepayments, the measure of how efficiently mortgage holders exercise their call option, was also low. So that was a great fundamental backstop for agency mortgages.

Low levels of volatility and a benign prepayment environment are not things we think would exist in perpetuity. We’re positing the portfolios to try to protect book value should either or both of this change directions. We have also used to run up a certain special type full pay-up to monetize some gains in our holdings when we see more attractive options elsewhere.

In terms of how we manage our portfolio this last quarter, we traded actively but did not make any large changes to the portfolio composition. We added some 15-year prepayment protective pools way below [ph] [indiscernible] there would drop and pay-ups would increase. That scenario has played out nicely since quarter end. We took some gains on the funds in 30-year pools. We also took gains on some reverse mortgage pools.

The portfolio that we bring into the third quarter consists primarily of pools that are loan balance related or MHA-related prepayment protection. In our opinion, these are the two most reliable forms of prepayment protection currently available. I believe we are well-positioned to weather an increase in prepayments or interest in volatility.

And with that, I’d like to turn the presentation back over to Larry.

Larry Penn

Thanks, Mark. While we’re pleased with our second quarter results, looking at returns for this one three-month period alone doesn’t give a complete picture. May 1st marked our one year anniversary as a public company. We’re extremely pleased with our strong consistent performance during our first year, in particular, our relatively stable book value during a tumultuous period for the agency RMBS markets.

For the past five quarters including the quarter when we went public, we’ve delivered an economic return of 6.6% or the average economic return for our agency REIT peers over the same period is actually negative.

Our outperformance was driven by active trading and dynamic hedging which enabled us to avoid the sizable book value decline suffered by many of our peers in 2013. Because of the way that we managed risk, we won’t be the highest line mortgage REIT when interest rates fall, but we believe that we’ll benefit from significantly more downside protection than our peers when interest rates rise.

Looking forward, we see the potential for increased volatility as a notable and perhaps underappreciated risk. Dealer risk appetites in balance sheets are now much smaller than they used to be. And the Federal Reserve is quickly phasing out quantitative easing.

It’s our view that the recent lack of volatility has lowered the marketplace into a false sense of security and it is masking what is actually a much shallower, more vulnerable market than what might appear on the surface. We believe that it’s likely that any sort of interest rate or prepayment shock will bring numerous dislocations and inefficiencies and therefore, many opportunities for us.

As I mentioned last quarter, while most of our capital is still deployed in agency-specified pools, we’re always keeping a close eye on the MBS derivatives market, in particular IOS which when priced right cannot only be efficient tools for managing interest rate risk but at the same time excellent generators of risk adjusted returns in their own right.

On Slide 11, you can see that at quarter end, we had about $14 million market value of IOS, down from almost $16 million at the end of the first quarter. Our current IO holdings are low because pricing levels are rich right now. But we believe that any significant interest rate movement whether up or down will likely make IO valuations more attractive and we’ll be ready to increase our holdings there when the opportunity arises.

This concludes our prepared remarks. And we’re now pleased to take your questions. Operator?

Question-and-Answer Session

Operator

The floor is now open for questions. (Operator instructions) We do have a question from the line of Trevor Cranston with JMP Securities.

Trevor Cranston – JMP Securities LLC

Hi, thanks, and congratulations on a good quarter.

Larry Penn

Thank you, Trevor.

Trevor Cranston – JMP Securities LLC

I guess the first thing – you guys talked a bit about the kind of underappreciated risk of increased volatility and there’s obviously some different ways you guys can protect yourselves against that. So I was wondering if you could just give a little bit more color kind of on how you guys put together your hedge positions when you’re thinking about kind of being short TBAs versus buying more swaptions and how that plays out in your portfolio.

Mark Tecotzky

Hi, Trevor, it’s Mark.

Trevor Cranston – JMP Securities LLC

Hi, Mark.

Mark Tecotzky

So we use both tools and what we do is we try to keep the amount at which the duration of the portfolio changes for given interest rate shifts a 10 basis points shifts or so within some manageable bend.

So really we have three tools to manage that. One tool is swaptions. The other tool is being short TBA mortgages because the TBA mortgages have the worst volatility exposure in the specified tools, so by short then [ph] you’re showing them your buying backs in volatility.

And the third thing is just rebalancing the portfolio periodically as the market moves. So one aspect of the second quarter which I think was helpful to return to help us as well as I’m sure you know our peer group was the fact that in second quarter, there was not a lot of big interest rate movements. So it didn’t require a lot of portfolio adjustments.

And that really contracts that to second and third quarter of last year where you saw this violent sell up in the market and then a rally back. So a lot of people sort of repositioned their portfolio when rates kind of hit a high and then missed out on some of the price appreciation they could have had if they had maintained their portfolio the way it was.

So it’s really those three tools. And we sort of are adjusting the relative importance of those tools as a function of sort of market dynamics.

Trevor Cranston – JMP Securities LLC

Got it. That’s helpful. And the second thing – Larry commented a little bit about the IO market at the end of the call there. And I was curious, it seems like IO valuations have remained pretty elevated even as mortgage rates come down some. So I was wondering if you guys can just comment on what you think is driving that and if you think kind of we need to see a new – a breakdown to a new kind of lower mortgage rate before the IO market starts to get concern about higher prepays?

Larry Penn

This is Larry. I think that we do need a move. I think that what’s driving the rich valuations frankly is performance. Prepayments have been muted. We’ve been now in a range – we’ve been ranged down in interest rates. We haven’t seen a big break out of prepayments.

So I think those IOs on an on hedge basis certainly are going to be spending out huge carry in the meantime. So we believe that the way that we look at the world which is on a relative value and on an option-adjusted standpoint, we think that this is not a good entry point. But on the other hand, if interest rates rise, we think that those people who are unhedged will take profits and that will create some selling pressure. They’ll basically extract it from the trade where they were looking for. And if interest rates fall, they’re obviously at that point and shocks [ph] again, those people that are unhedged are probably going to be selling for worse reasons.

But as long as we stay in this range and as long as prepayments are relatively benign which is course related to staying in the range, there are probably not going to be a lot of crack to the IO market.

Trevor Cranston – JMP Securities LLC

Got it. And when you guys look at kind of projection refinancing activity, is there kind of a key level you guys think about for kind of the conforming mortgage rate that they then could start to trigger some more meaningful activity?

Larry Penn

Well, I think it’s really two things. So one is you have to look at the distribution of note rates in the existing mortgage stocks. So it’s one of the reasons why the refi index has been so low right now. You had – so even though rates are low now, you have a lot lower rates 2012-2013, so it shifted a lot of the current mortgage holders into 3.50% to 4% 30-year note rates. So they don’t have an incentive. So it’s one big chunk of the population that has no incentive to refi and that keeps the refi index low. And I think you need at least a 25 basis point drop to really change – to really move a significant number of borrowers into a rate environment where they have sufficient incentive to refinance.

But if you look at individual coupons and individual cohorts, there you’re really starting to see activity so 2014 and 2013 Fannie 4.5 paid [ph] relatively quickly. So even though it’s not a big enough cohort to really raise the refi index a lot, on an individual pool basis and not a coupon basis, it can be impactful enterprise [ph].

Trevor Cranston – JMP Securities LLC

Got it. That’s helpful. Thanks a lot for the comments.

Larry Penn

Thanks, Trevor.

Operator

And our next question comes from the line of Jim Young with West Family.

Jim Young – West Family Investments

Hi, you’d mentioned that in the reverse mortgages that you took some profits given this tightening in spreads. I’m just wondering how you’re thinking about that market at this point. What kind of returns do you think you can generate from the reverse mortgages?

Larry Penn

When we first bought those, they looked to us when we valued – they don’t have a lot of negative convexity, they don’t have a lot of optionality in them. It looked like they were somewhere 85 to 90 basis points off the curve, which was this wide for agency credit once you take into account the prepayment risk.

And this come in now to say 55 or so. So they don’t look to us super expensive. When you look at every part of events and create fixed income, that tightening probably matched by what you see in the best of great corporate or what you’ve seen on the operated case series bonds.

It’s just for we think additional tightening from here is going to sort of be hard fought for them and a slower slug. So we’d rather sell then and get into some other kind of pools where we think you’re going to have more pay-up volatility.

So I don’t think they’re a bad investment here at all. But just they’ve kind of achieved the spread target we had set for them. And we think that there’s maybe some more opportunities looking at pools that we cannot pay a lot for the prepayment protection now, but might have a significant increase in valuing the future.

And they’re also part of the reason why they were cheap and still trade wider as a liquidity.

Jim Young – West Family Investments

Yes.

Larry Penn

They’re not nearly as liquid as 30-year or even 15-year mortgages. So we feel that if there is any selling or increased supply, that could put pressure on that sector pretty quickly. So we just decided to take some profits there.

Operator

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

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