Ellington Residential Mortgage REIT (NYSE:EARN)
Q1 2016 Earnings Conference Call
May 04, 2016 11:00 AM ET
Maria Cozine - IR
Larry Penn - CEO
Mark Tecotzky - Co-CIO
Lisa Mumford - CFO
Steve DeLaney - JMP Securities
Douglas Harter - Credit Suisse
Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT First Quarter 2016 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 Maria Cozine, of Investor Relations. You may begin.
Thanks, Camilla. Before we start, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature. As described under Item 1A of our Annual Report on Form 10-K filed on March 10, 2016, 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 on the call with me today Larry Penn, Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer. As described in our earnings press release, our first quarter earnings conference call presentation is available on our Web site earnreit.com. Management's prepared remarks will track the presentation. Please turn to Slide 4 to follow along. As a reminder during this call we’ll sometimes refer to Ellington Residential by its NYSE TICKR E-A-R-N, or EARN, for short.
With that, I will now turn over the call to Larry.
Thanks, Maria. It's our pleasure to speak with our shareholders this morning as we release our first quarter results. As always, we appreciate your taking the time to participate on the call today. First, an overview; on a fully mark to market basis Ellington Residential had a small loss of $0.03 per share in the first quarter. In some sense the first quarter results is similar to recent quarters. Extreme interest rate volatility made hedging extremely challenging, MBS yield spreads continued to widen. And longer term interest rate swap spreads tightened, in this case moving further into negative territory.
While recent quarter have been challenging, we’ve preserved capital through them and has Mark will describe later, we’ve reached a point, where we believe that the risk reward for agency RMBS, is as good as we seen in a while. As an expression of that view, as you can see on Slide 18 of the presentation. We’ve paired down our TBA short positions with the result that they now represent as lower portion of our hedging portfolio as they has since our IPO.
We’ll follow the same format as we have in 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 portfolio and what our market outlook is. Finally I will follow with some additional remarks, before opening the floor to questions, go ahead Lisa.
Thank you Larry and good morning everyone. In the first quarter, we had a net loss of $239,000 for $0.03 per share the components of our net income were as follows. Our core earnings totaled approximately $4.9 million or $0.53 per share, net realized and unrealized gains from our securities portfolio were $11.6 million or $0.28 per share and we had net realized and unrealized losses from derivatives of $16.7 million or $0.83 per share. Excluding the net periodic cost associated with our interest rates swaps. Our core earnings, includes the impact of catch-up premium amortization which in the first quarter increased our core income by about $260,000 or $0.03 per share.
Catch-up premium amortization is calculated based on interest rate levels and pre-payment projections at the beginning of each quarter, in this case interest rates has recently risen at the beginning of the first quarter and future pre payments were projected to slow down, as a result, thus leading to a positive effect on interest income from the amortization adjustment. If we subtract the catch-up premium amortization adjustment, which tends to be volatile from quarter to quarter, our core earnings amounted to $4.6 million or $0.50 per share in the first quarter. On that same basis our fourth quarter core earnings was $0.61 per share.
The quarter over quarter decrease in our core earnings adjusted to exclude the impact of catch-up premium amortization, which principally is the result of the decline in our interest income, if we exclude the impact of the catch-up premium amortization adjustment from our interest income, in the first quarter our interest income was $9.3 million as compared to $10.4 million in the fourth quarter, the decrease in our interest income was related to two main factors. First it declined because of the decrease in the size of our portfolio. On the basis of amortized cost, our total MBS portfolio was $1.16 billion as of March 31, 2016 as compared to 1.239 billion as of the end of year. This decline of approximately 79 million accounts for about one half of the drop in interest income.
Second the weighted average book yield on our portfolio excluding the catch-up premium amortization adjustments declined about 14 basis points to 3.04% and this accounts for the remainder of the decline in interest income. Also impacting our core earnings was a slight increase in our cost of funds. As noted in our earnings release our cost of repo increased during the quarter, but this was partially offset by a decrease in the periodic cost associated with our interest rate hedges. Our interest rates swaps make up a large component of our cost of funds and during the first quarter they slightly decreased both in terms of motional sides consistent with decline in the size of our asset portfolio and in remaining average maturity consistent with the drop in the effective duration of our agency pooled portfolio.
The net impacts of the increase in our cost of funds was small at approximately $100,000 or $0.01 per share, our net interest margins, excluding the impact of catch-up premium amortization adjustment was 1.83% for the first quarter as compared to 2.01% for the fourth quarter. Quarter-over-quarter our total expenses increased slightly, including base management fees our total expenses increased to 1.4 million in the first quarter from 1.2 million in the fourth quarter or $0.02 per share. Overall while there may be some slight variation in certain line items we expect our total operating expenses in 2016 to be similar to what they were in 2015.
As I mentioned our cost of repo increased during the first quarter, while the cost of repo has increased and there is additional market demand for repo given the FHLBs decision to ban in insurance captures from membership in the FHLB system we had found dealer appetite for repo lending to continue to be strong. Since quarter end we've seen a slight easing in repo borrowing rates.
During the first quarter we turned over approximately 48% of our agency RMBS portfolio which generated net realized gains of approximately $4 million or $0.44 per share in addition this portfolio and our non-agency RMBS portfolio each depreciated in value resulting in unrealized gains of $10.1 million or $1.11 per share. However the decline in interest rates and high level of market volatility led to unrealized losses on our interest rate hedges which offset the net realized and unrealized gains on our MBS securities.
We ended the quarter with book value per share of $15.39, which when compared to the $15.86 per share at the end of the fourth quarter of 2015 essentially reflects the payment of our first quarter’s dividend in the amount of $0.45 per share. Adjusted for unsettled purchases and sales our leverage ratio was 7.7 to 1 slightly lower than it was at the end of the fourth quarter at 8.1 to 1. Our equity, relative to December 31, 2015, was slightly lower, and our portfolio size also slightly declined as I mentioned earlier.
With that, I'll now the turn the presentation over to Mark.
Thanks, Lisa. This is a quarter of extreme market volatility where we basically broke even, as has been our policy since inception we try to inflate investors from interest rate risk and unlike some others in the mortgage REIT space, we try not to operate with a large duration gap, positive or negative. Maintaining a neutral interest rate positive when interest rate volatility is high can be a drag on returns but it helps to stabilize book value in violet sell offs like the tapered income instead we focus on driving returns with thoughtful prepayment choices, active training and careful pool selection.
In the space of big interest rate movements we saw in the first quarter projected prepayments to be done agency MBS changed within the quarter with their durations shortening in the early part of the quarter as rated dropped. At duration exchange you have to rebalance our hedges in order to control our interest rate risk. That rebalancing is a drag on returns and that impacted our performance in the quarter. Rate volatility declined in the second half of the quarter and it remained relatively low so far to the second quarter this return to a more normal interest rate environment has helped performance so far after quarter end.
The way that we have positioned the portfolio going into the first quarter protected it from large prepayment increases and our actual CPRs only increased a little less than 1 CPR over the quarter less than the market as a whole while the refi index more than doubled from peak to trough during the first quarter our prepayments speeds were much better behaved. These lower realized prepayments speeds helped to preserve the yields on our mortgage holdings in a declining interest rate environment, leading directly to higher NIMS and higher core earnings as our hedging cost dropped.
During times when the market is moving quickly from a higher rate to a lower rate environment like we saw in the first quarter the dynamic hedging adjustment is the headwind. However once you reach the lower rate environment and see some stability you reap the weaker benefit in lower hedging costs both from lower stock rates overall and from being able to shift more of your hedges to a shorter part of the yield curve. Another benefit of having a slow paying portfolio in a fast prepayment environment is the cost of our TBA hedges has dropped materially.
Slide 7, shows the monthly cost of the TBA shorts in FN4s taken by averaging a 60 day moving average of the roll in FN4s. Yes it's actually the annual cost. The recent drops in the roll market for the most actively traded coupons mainly come from increasing prepayments on TBA type pools together with much larger tradable floats in these coupons with the Fed having not been a net buyer for well over a year now. Now it was nice enough to have a slow paying portfolio when overall market prepayment speeds were slow as they were before the recent rally since slower speeds mean higher yields what is even better than the slow paying portfolio when overall market prepayments speeds are fast as they are now. In this environment rolls are lower so our TBA hedging costs are lower.
Look at the table on Slide 8 and what happened in the April prepayment report. There was a big divergence in speeds between pools with and without prepayment protection. Generic Fannie 3.5s has been paying about 10 CPR from March -- from December to February. In March, they increased to over 24 CPR. On the other hand, the loan balance Fannie Mae 3.5 has been paying six CPR from December to February they only increased a 7 CPR. So you can see that the CPR difference between the loan balances from generic pools has increased dramatically. The prepay insurance we bought in higher rate environments is benefitting us now.
MBS underperformance was a headwind for us in the quarter but this underperformance was modest compared to other sectors and should be expected in times of extreme market volatility. In fact given the substantial under performance of the S&P high yield indices and CMBX, the S&P high yield indices and CMBX agency MBS actually held very well. Look at the graph on Slide 9, this shows the performance of the S&P, CMBX index referencing, CMBX in pieces and high yield bond index, with everything all normalized to 100% at the start of the quarter.
Asset classes with very different risks where nonetheless were highly correlated through the middle of February with all 3 entities hitting their trough on February 11th. RMBS underperformance was modest given the enormous movements in other markets. Going forward we are constructive on mortgage spreads, agency RMBS are liquid, they don’t have credit risk and they yield a lot more than G3 sovereign bonds. One emerging trend for the quarter was an increase in foreign buying of agency RMBS. We show on sub Slide 10. Faced with negative yields on Japanese 10 year notes, it is not surprising that Japanese investors have an interest in high yielding liquid agency RMBS.
While our own Central Bank executed the first rate hike in December both the ECB and the DOJ went the other way providing more stimulus in the quarter. We attribute the recent increase in foreign sponsorship of agency RMBS as a response to the wider yield gap between agency RMBS and foreign sovereign bonds. So we remain at substantial yield pickup in agency RMBS relative to Japanese 10 year bonds even after hedging out the currency risk. While hard to quantify the broad based to fill the agency RMBS or moderate underperformance in the first quarter, we believe with new sponsorship along with the continued sponsorship from bank, and insurance companies and money managers will be a stabilizing factor for agency RMBS yield spreads for a while to come, that spread volatility should stabilize book value movements and potential allow us to capture a greater portion of our NIM in our earnings.
We actively turned over the portfolio during the first quarter and we expect continued trading activity. Declining dealer appetite to hold inventory, feeds more opportunities for us to capture inefficiencies and turn them into trading gains. The great liquidity of the agency RMBS market was narrow bit of spreads, allow us to drop most of the trading gains to the bottom-line as opposed to having a leak away into office spreads. Active trading allows us to root at our portfolio into the most attractively price forms of prepayment protection. We think that active trading is increasingly important as prepayment protection is now in the money not out of the money as we discussed down in the earlier side.
Despite our active trading, the composition of our portfolio did not change significantly during the quarter. As you can see on Slide 14, we shrunk our portfolio slightly keeping our leverage roughly constant given our book value decline. We held onto a lot of our prepayment protection. The price of past has increased and we are always trying to get the best prepayment potential for the lowest payouts.
With that, I’ll turn the call back over to Larry.
Thanks Mark. In the early part of the first quarter, our stock price declined somewhat relative to our $15.86 year-end book value. And in light of this wider gap, we repurchased a modest amount of shares at an average price if $10.94. While going forward, we expect to continue to opportunistically execute share repurchases. We also continue to be mindful as a small company of the effect that shrinking our capital base would have in our expense ratios and on the liquidity of our stock. Our focus remains on enhancing shareholder value and generating attractive returns over the long-term.
We’ve been talking recently about reallocating more of our capital from our agency strategy to our non-agency strategy and also to the agency IO market. Given how wide yield spreads are on agency pass throughs now, we remain in no hurry to do this. As non-agency RMBS yield spreads widen during the first half of the quarter we almost but not quite reached the entry point we were looking for. In the agency IO market mortgage rates are now again nearing an inflection point where a big prepayment wave could be coming and as a result we believe that many IOs are currently extremely overvalued from a risk reward standpoint and could experience a big shakeup should interest rates fall further.
We are committed to being disciplined about a possible portfolio realignment, and we view the current simplicity and liquidity of our portfolio as a huge benefit to the Company in this market environment. The first quarter vividly exposed both the fundamental vulnerabilities and the technical vulnerabilities in the credit markets. Easy monitory policy has resulted in a lot of yield chasing and we believe that many credit sensitive sectors of the fixed income markets, especially after the stunning recovery in the second half of the first quarter, are underestimating the risks presented by global economies that are truly week, and structural changes in energy and commodity markets that maybe here to stay.
The first quarter showed just how exaggerated market moves can be and just how wild the rush to the exits can be, when sentiment changes in the credit markets, we believe that Ellington Residential shareholders are best served by our continuing to be patient and disciplined in our choice of entry points. While being a small company has its drawbacks, our nimbleness is definitely a big asset in this regard. Meanwhile, we believe that the agency RMBS market is providing excellent opportunities, although prepayment risk is currently heightened, we believe that this is actually a plus for us. As our strong analytical team and proprietary technology adds more value in an environment where prepayment risk is not only greater but varies so divergently by loan characteristics, servicer behavior and many other factors, operator?
The floor is now open for questions. [Operator Instructions] Your first question comes from Steve DeLaney of JMP Securities.
Good morning, everyone. Larry, my first question was going to be what the shift were formerly agency REITs moving into credit and hybrid but your closing remarks pretty much covered that and I guess maybe the right of way to look at it is the opportunity in agency is there for those that really can get the prepay risk right and have the ability to dynamically hedge, because we saw several double-digit book value losses in agency strategies in the first quarter?
And that was done in a down rate environment, so, that's happened sometimes more in an up rate environment, so yes, as said before, we like the value in the agency market right now but given how fragile at times the non-agency market seems to be and although the IO market hasn't been fragile we think that it probably should be more fragile than it is and it could really come under some pressure, if rates go down in other let’s say 25 basis points, so, we wanted to be disciplined and as I said, we really value the liquidity of our portfolio, we could turn on a dime, I think, if we want to, I think having a liquid portfolio has a lot of ancillary benefits even above and beyond that. So, yes I think we covered that.
Yes, all right. And obviously swap spreads were a big part of it especially with people with a very long duration on their swaps. Do you see a reasonable scenario where we would see a reversal in this swap tightening? It seems that it all other things equal that would obviously have a very direct benefit on your NAV it we were to get some widening there?
So, a few considerations, one really important consideration for us, is that the floating rate negative swap, how closely that tracks our repo expenses and one very good piece of news in the last few months, was that the floating rate of the swap where we get, where we're paying six and receiving three months LIBOR, when we finance for a three months period of time, our repo costs have been very, very close to the three months LIBOR receiving on the swaps. So, that's one important consideration, swap spreads in the long end, they have become less negative in the last few weeks, I think a few technicals, one is that it's impacted by the size of the treasury auction calendar. There's been some stuff written that you have to see decreasing amount of treasury issuance that can be a catalyst of revenue swap spreads become less negative, the other thing is short squeezes that can occur in treasury bonds and you saw some of those in the first quarter that can be another factor that can make swap spreads less negative.
Okay. That's helpful. And you mentioned -- Lisa mentioned in her remarks that you had actually seen some improvement in agency repo rates since quarter end. It you give me an idea of what you're seeing currently in 30, 60-day repo or the range of quotes?
Yes so I can range 90 -- we are not going out longer like the 90 day repo and it has been I think somewhere between 68 and 70 basis points of LIBOR plus now back into the single-digits. I think the biggest positive trend that we saw in repo the last two months was a reemergence of some large U.S. banks wanting to grow their agency repo book. So one trend that had been in place for the last couple of years, it is sort of a changing of the guard as to who was providing repo and you saw a lot of smaller broker-dealers entering the repo market and then a reversal of that trend occurred a little bit in the last couple of months that we saw a large U.S. banks that had not had a substantial interest in agency repo wanting to re-enter the market and aggressively looking to increase their repo exposure with us and that, I think is a good think, because rate matters but also the size the sort of staying in power of our counter parties is also very important, we like to have repo counterparties that we can sort of count on through market cycles and having a big bank which big, U.S. banks have access to most unlimited funding is zero, having them as a repo counterparty, who just smaller broker dealer. We view that as positive.
That's very good color, Mark and I had actually not heard that, I had not heard that we were having any tightness in repo but obviously the banks are -- that's the kind of muscle and clout that you need to have a really safe, deep market. Are you getting any sense of what the bank's motivation is because everything we've heard with the capital standards and liquidity rules and everything would be that that would be negative to repo. So I'm surprised that the banks are stepping up.
You know, I don’t know, so just going to calculations I think, they have had some time now where they have been trying to right size their balance sheet so may be, some of them are pretty far along in that process and now they just look at it as an asset, right? Getting paid 70 basis points with a big haircut on something liquid, they probably view that as favorable versus, what they are getting on some of the shortest type quality floaters they can buy.
Sure, sure. Okay. Well guys, I appreciate the comments. Thank you.
I just wanted to add one more thing [Multiple Speakers].
Yes go ahead.
I mean it’s not, look we have to make choices, when we hedge and it’s not I wouldn’t say that it’s our core business, to prognosticate swap spreads, but nevertheless we have to make sure it’s right and I think that if you look at a negative ten year swap spread and we do have swaps that are tend to be longer duration right, because our assets, on our longer duration and we try to match our assets and liabilities. So, we try to be disciplined about that. If you look at say, swaps in the ten-year area, I mean negative swaps spreads are a recent phenomenon, I mean there was a blip a few years ago but getting to these types of negative levels, is a very recent phenomenon and it’s one that I think there are some structural changes that are permanent so for example, now that interest rate swaps are essentially cleared, I think that’s helped tighten swaps spreads because I think a lot, not all but a lot of the credit risk that was previously [Multiple Speakers] where the market is? Is somewhat off the table, right so that's certainly helpful and that's here to stay.
On the other hand there is a lot of technical factors involving balance sheet and people preferring to do things off balance sheet versus on balance sheet that has have people basically except these much lower rates receiving rates on long-term contract that you get on treasury then, I personally am not convinced that that is something that will necessarily be here over the long-term and if you look at how, swap spreads got out to what a negative 17 or something like that, in a ten year [Multiple Speakers] and I think that they seem to have pretty good support there, so from a risk reward standpoint, we are at least at this point, in no hurry to change that position, because we think that, of course there is risk of swap spreads receding but we think there is a limit there. There are arbitrages that you can do if you've got the balance sheet buy right to buy treasuries lever them up and basically earn that difference between treasuries and swaps over the term of the contract so that’s going to be a regulating factor as well. So I like the position we are in and I think that obviously it’s been painful for the last call it six months if not nine month in terms of where swap spreads have gone but, we’re here and we like the position that that leads us there.
That's great. And Larry, when you take that slight widening in swap spreads maybe four or five basis points, other conditions in the market, is it reasonable for us to assume that your book value has probably improved somewhat from the 15.39 level at March 31 given the general movement in the market?
Yes. We don’t typically like to give guidance on book value, post quarter end but I think that you did, hear Mark say that there have been a lot of things whether it be spread tightening, a spread tightening in the agency markets since quarter end. I would put swap spreads in the same category that, if you work to extrapolate right with our portfolio, it should imply a decent performance since quarter end.
Your next question comes from Douglas Harter of Credit Suisse.
Can you talk about how pay-up prices have performed relative to the change in CPRs and how that might compare to prior periods where rates have fallen?
Sure. This is Mark so that's a good question in the first quarter our view was you saw the very violent drop in interest rates through the middle of February and pay ups appreciated materially but that appreciation was sort of inline or an expectation it was in line with what you would have assumed given that dropping rate so we think pay up performed sort of as expected, they didn’t do better they really didn’t do worse. But since then and I were back to tenure of 180 I mean it got to 160 mid quarter and pay ups really have sort of stayed where they were sort of when rates were a little bit lower so I’d say from mid February to now pay ups have outperformed and one aspect to the market that we mentioned in the call and have a slide about it is that the rolls have generally been -- are at lower level so they are less expensive shorts so for certain arbitrageurs it's more compelling now to have such wide pools and hedging those with TBAs because your monthly cost of the roll and sort of your borrowing cost has gone down so that dynamic has been supportive of prepayment has been supportive of pay ups as well.
And then the other aspect that again we try to document in the slide was the prepayment report of your March activity which was released the first week in April, there were some surprises there, so I wouldn’t anticipated a big increase in prepayments and you got a big increase in prepayment if we documented what happened to a couple of the large cohorts 2014 Fannie Mae and 2014 putting forward really the 2014 really un-prepay protected pools to jump from 11 to 24 that was a bigger move than what the market thought and that had some investors scrambling for cover in the form of prepayment protection so that prepayment report was also in support of the pay up levels.
And I just -- let me just add one thing Mark which is that when you have big moves like we had in the first quarter and especially, well actually it could happen either one when we are going up or going down but there were these downward moves in the credit market right. And one of the things that happened is sometimes the liquid products move more than the less liquid products and all of our agency products are fairly liquid but sometimes you will see bigger moves for example you will see bigger moves in indices than you see in individual corporate bonds for example that was one phenomena that we definitely saw in the first quarter. I think similarly here some of the moves that you will see the specified pool pay ups for example sometimes in a market environment like that where people are really focusing on the most liquid product sometimes you will see that pay ups in that case in a down rate environment don’t move as much as we might otherwise had hoped, but I think one thing that we've seen overtime is that if you are patient things will catch up. And so we like the position and we especially like it given that we could be on the cusp of our prepayment wave especially if things move down further and again initially sometimes the moves are not as big as you want them to be or as your models said it should be, but if you are patient usually things do go back to where the more theoretical value or closer to where you think they should be so we are expecting that to catch up even more than we thought it would be.
There are no further questions at this time. Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT's first quarter 2016 financial results conference call. Please disconnect your lines at this time, and have a wonderful day.
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