Ellington Residential Mortgage's (EARN) CEO Laurence Penn on Q3 2017 Results - Earnings Call Transcript

Ellington Residential Mortgage REIT (NYSE:EARN) Q3 2017 Results Earnings Conference Call November 3, 2017 11:00 AM ET

Executives

Maria Cozine - VP, IR

Laurence Penn - CEO, President and Trustee

Lisa Mumford - CFO and Treasurer

Mark Tecotzky - Co-CIO

Analysts

Steve Delaney - JMP Securities

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT 2017 Third Quarter Financial Results Conference Call. Today's call is being recorded. At this time all participants have been placed on 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, Vice President of Investor Relations. You may begin.

Maria Cozine

Thanks, Lori. 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 13, 2017, 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 statement 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 third quarter earnings conference call presentation is available on our website, earnreit.com. Management's prepared remarks will track the presentation.

Please turn to Slide 3 to follow along. And as a reminder, during this call, we'll sometimes refer to Ellington Residential by its New York Stock Exchange ticker E-A-R-N, or EARN, for short.

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

Laurence Penn

Thanks, Maria. It's our pleasure to speak with our shareholders this morning as we release our third quarter results. As always, we appreciate your taking the time to participate on the call today.

For yet another quarter, volatility persisted at or near historic lows and spreads across many fixed income asset classes remained at or near their 2-year tights. Once again, the yield curve flattened and long-term interest rates remained range-bound.

However, a key difference in the third quarter, which really separated this quarter from the first half of the year, was that Agency RMBS finally participated in the spread tightening that most other fixed income asset classes had already benefited from earlier this year.

In September, when the Fed provided more clarity to investors by announcing the specific timeline to begin the tapering of its balance sheet, we saw a rush of investors adding Agency RMBS exposure.

Going forward, as the Fed continues to reduce its footprint in this space, we expect a lot of the slack to be taken up by mortgage REITs. In fact, residential mortgage REITs have raised over $8 billion of new capital so far this year, which after leverage translates into around $40 billion of the Agency RMBS buying power.

EARN was well positioned to take advantage of the tightening that occurred in the third quarter. Not only had we reduced our TBA short position in advance of the tightening, but we had also completed deploying the proceeds from our second quarter equity raise.

We are extremely pleased with the timing of that equity raise as we were able to fully deploy the proceeds and then benefit almost immediately from the strong Agency RMBS performance. Our strong third quarter results once again demonstrate that our strategy is adaptable to diverse market environments.

Our second quarter equity raise has also delivered another great benefit, namely to our expense ratios. The larger equity base resulting from the raise lowered our annualized expense ratio by a full 60 basis points to 3%.

Along with the strong portfolio performance, our lower expense ratio helped us achieve an annualized economic return for the quarter of a robust 12.8% and GAAP net income for the quarter of $0.48, which more than covered our $0.40 dividend.

We'll follow the same format on the call today as we have in the past. 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. And then finally, I'll follow with closing remarks, and then we'll open the floor to questions. Over to you, Lisa.

Lisa Mumford

Thank you, Larry, and good morning, everyone. In the third quarter, we had net income of $6.3 million or $0.48 per share. The main components of our net income were: core earnings of $5 million or $0.38 per share; net realized and unrealized gains from our securities portfolio of $4.5 million or $0.34 per share; and net realized and unrealized losses from our derivatives of $3 million or $0..23 per share.

By this measure, net realized and unrealized gains from our derivatives excludes the net periodic cost associated with our interest rate swaps since they are included as a component of core earnings.

Our core earnings includes the impacts of catch-up premium amortization, which in the third quarter decreased our core earnings by approximately $667,000, or $0.05 per share.

After backing out the catch-up premium amortization from interest income in both the third and second quarters of 2017, we arrive at our adjusted core earnings of $0.43 per share and $0.47 per share, respectively.

The primary factor driving the net decrease in the quarter-over-quarter adjusted core earnings per share was compression in our net interest margins. In the third quarter, our net interest margin, adjusted to exclude impacts of catch-up premium amortization, was 1.45% as compared to 1.63% in the second quarter.

While the average yield on our portfolio also adjusted to exclude the impacts of catch-up premium amortization remained constant at 3.01% quarter-over-quarter, our average cost of funds increased to 1.56% in the third quarter from 1.38% in the second quarter.

This increase was mainly driven by the increase in our repo borrowing costs with a partially offsetting slight decrease in our cost of swaps and U.S. Treasury hedges, which are also included in our cost of funds. On a per share basis, the quarter-over-quarter increase in our cost of funds is equivalent to approximately $0.06 per share.

On the other hand, our adjusted core earnings benefited from a decline in our expense ratio. Our expense ratio declined as a result of our larger equity base, which increased because our equity issuance activities, including our second quarter secondary offering as well as through our ATM program.

While our equity base expanded the nature of our expense base to such that most of our expenses do not increase proportionately to the increase in our equity, our annualized expense ratio declined 60 basis points to 3%. And this reduction resulted in an approximate $0.02 per share benefit to adjusted core earnings this quarter.

Our Agency RMBS turnover during the quarter was a bit less than usual at 17%. But we added to the size of our portfolio with the proceeds from our ATM offering. As a result, our Agency portfolio increased to $1.7 billion as of September 30 from $1.6 billion as of June 30. While we had a small net realized loss in the sale activity, we also had net appreciation on our portfolio.

During the third quarter, net realized and unrealized gains from our Agency portfolio were $3.8 million or $0.29 per share. We also continue to have a small portion of our assets invested in legacy non-Agency RMBS and we trade that portfolio.

In addition to generating interest income, our non-Agency portfolio generated net realized and unrealized gains of approximately $700,000 or $0.06 per share.

Our interest rate hedging portfolio continues to be prominently made up of interest rate swaps and short TBAs, and to a lesser extent, short U.S. Treasuries and other instruments. Excluding the periodic swap costs included as a component of core and adjusted core earnings, our interest rates swaps generated net gains for the quarter.

Our TBAs generated losses, but roll costs declined quarter-over-quarter. So even though our TBA hedge increased slightly in size on a 10-year equivalent basis, their overall per share impact decreased to $0.33 per share in the third quarter from $0.44 per share in the second quarter.

We ended the quarter with a leverage ratio adjusted for unsettled purchases and sales of 8.3:1, slightly lower than 8.5:1 as of the end of June. As of quarter-end, we had total equity of $196.8 million or book value per share of $14.76 as compared to $181.9 million or $14.71 per share as of the end of June.

Through our ATM program, we sold approximately 958,000 shares at an average price per share of $14.49 for proceeds of $13.9 million. Our economic return for the quarter was 3.1% or 12.8% annualized.

I would now like to turn the presentation over to Mark.

Mark Tecotzky

Thank you, Lisa. The third quarter saw mortgages substantially outperform both swap and Treasury hedges, putting in their best performance of 2017. During the second quarter or doing the same quarter, we had both the North Korea scare that took 10-year yields down to about 2% and the Fed finally announced that they would be allowing their MBS and Treasury portfolios to start running down.

That process started in October. So how do you explain this great mortgage performance in the face of what many pundits would consider both a challenging macro and technical backdrop?

One of our main points on our last call was how poorly MBS had previously performed relative to other spread products. Investment-grade and high-yield corporates as well as structured products had all been tightening throughout the year.

But MBS investors seemingly wanted more clarity from the Fed about potential balance sheet reduction before allocating to this space. Well, once we got the clarity on both timing and quantity of the Fed's balance sheet reduction, mortgages really began to outperform.

You can see on Slide 5 that despite the strong performance this quarter, Agency MBS still has room to catch up to most other fixed income asset classes. Putting the direct effects of Fed policy aside, mortgages continue to benefit from a low volatility environment and tame prepayment rates. These tailwinds helped performance in the third quarter as they had in the previous two.

We added mortgage assets, thinking that any widening in front of the Fed would prove to be a good buying opportunity, and since we added mortgages, have indeed done very well. We have taken a portion of this additional leverage off since then and plan to wait for some type of systemic widening before adding more. That said, our view of mortgages remains pretty favorable overall.

In the quarter, REITs were their own best friend. By that, I mean that capital raises by mortgage REITs naturally resulted in substantial mortgage REIT buying of Agency MBS. This set off the virtuous cycle of MBS performance, leading to higher mortgage REIT book values, leading to more REIT equity capital raises and so on.

Even potentially more important, the entire supply-demand imbalanced calculation for MBS has potentially been flipped on its head. Previously, the market was concerned that the Fed's tapering would leave a hole that was too big to fill. Now there is the prospect of mortgage REITs being incremental buyers of Agency MBS in quantities unseen since 2013.

To put this in context, in October, the Fed only shrunk its MBS portfolio by $4 billion, assuming 7x leverage that was completely absorbed by just 1 $600 million mortgage REIT capital raise. Viewed through that lens, the October Fed tapering seemed eminently manageable. However, this calculation that gets less compelling the further forward you look.

In April 2018, for example, when spring seasonal factors typically cause an uptick in MBS supply, the Fed is scheduled to have been shrinking their MBS portfolio by $12 billion a month.

That has the potential to create a different dynamic. But at least through the winter, when seasonal MBS supply is low, the Fed balance sheet reduction should be easily digested.

Prepayment speeds were well contained in the quarter. Despite relatively low prepayment speeds, the cost of prepayment protection went up. We think this is explained by the heightened geopolitical risk and fears that crept in when the 10-year yield tested at 2% level in the first week of September.

Despite the sell-off in the 10-year back to the 2.35% to 2.40% range, the cost of prepayment protection has stayed elevated. One big positive for the specified pools that we own is that as the Fed reduces its footprint, TBAs tend to under perform relative to specified pools.

And this illustrates another aspect of the virtuous cycle of REIT capital raises, which typically buy many more specified pools than TBAs. And so those capital raises add support to the specified pool sector both on an absolute basis and relative to TBAs.

One potentially important policy change on the horizon popped up this quarter. Senator Elizabeth Warren contacted Michael Bright, acting Head of Ginnie Mae, about some aberrationally fast prepayment speeds on VA loans from some non-bank originators. Speeds on some VA cohorts from certain non-bank originators have been well in excess of 80% CPR.

On our last earnings call, we highlighted the prepayment ramp in the Ginnie Mae sector, and we've updated it here on Slide 6. You can see how these elevated prepayment rates are conserved for both investors and borrowers alike.

At EARN, we've been aware of this dynamic, and we profitably built the Ginnie Mae portfolio for EARN that avoids these bad actors. And in fact, EARN have been short TBA Ginnie Maes, where this prepayment behavior is concentrated.

Another thing supporting payment for specified pools is the potential for a steeper S-curve as a result of evolving technological changes. We tried to highlight something relevant to these technological changes on every earnings call.

And this quarter, the choice was easy. Slide 7 shows a Wall Street Journal article that ran in August. Their story talked about how Freddie Mac and United Wholesale Mortgage completed the first e-closing of an agency mortgage loan.

The entire process occurred online with the final closing of the $290,000 loan occurring on the borrowers' kitchen table with the mortgage broker present. The prepayment seemed poised to be affected by advancing FinTech, a theme we will continue to monitor.

Given that interest rates have been relatively range-bound, overall prepayments haven't been too exciting. We continue to find pockets of value and trading opportunities, such as the Ginnie Mae opportunities I mentioned previously.

Our portfolio turnover generally picks up during times of volatility, so we're pretty happy with our Agency portfolio turnover for the quarter at around 17%. While it's a small part of the overall portfolio, we did sell some of our non-Agency assets in the quarter -- in the portfolio this past quarter. Non-Agency spreads have tightened throughout the year. And they're at a point where freeing up some of that capital seemed prudent.

We think that in the current environment, the MBS market can absorb the first 6 months of Fed tapering basically through next March without repricing wider. This represents $36 billion in additional MBS supply, which is about 12% of the total expected 2017 net supply.

After that, starting in April, if the Fed sticks with their schedule, they will be shrinking $12 billion a month while seasonal supply increases. At that point, we believe MBS may need to reprice wider from price buyers -- to entice buyers to absorb the additional supply. If you project out overall of 2018, total Agency MBS outstanding is expected to increase by $250 billion.

But the Fed's tapering schedule has its outstanding portfolio decreasing by $168 billion. So that's a net hole of $418 billion that needs to be filled by private capital. So that's a pretty big number.

So in our view, the short-term view of MBS performance still lags other spread products on the year. And so MBS still offers a fair amount of relative value despite durations having recently extended a bit in the recent sell-off.

Prepayments for the time being are very manageable and very predicable. So while MBS is tighter on a nominal spread basis, it's by no means at a level that concerns us in the near term.

We mentioned earlier that we took off some of the leverage we had added previously. But we would definitely look to add some of that back in the event of some macro widening.

As we head in the last quarter of the year, the dynamics in the fixed income market are slowly shifting. Central banks are finally stepping back from QE. The Fed is ahead of the BOJ and the ECB. But they all seem be following the same path. First, they slowed down their buying, this is where the ECB is now, then they stopped net buying, so their portfolio size stays constant.

And then they start allowing the portfolio to shrink. This is where the Fed is now. Current spreads and volatility provide ample opportunities to generate returns. Our low leverage and disciplined, balanced approach to hedging has us well positioned to take advantage of any dislocation.

With that, I'll turn the call back to Larry.

Laurence Penn

Thanks, Mark. Markets are currently pricing at an additional Fed rate hike in December and changes in the tax code now look a bit more likely. But with Janet Yellen's term coming to an end in February and with the economic and geopolitical landscapes each full of conflicting signals, the path forward for both short-term and long-term interest rates is unclear.

It's impossible to predict how long this low volatility environment will last or whether long-term interest rates will finally break out of their recent range. Meanwhile, the entire fixed income market is priced assuming that volatility remains low. So if all we did was buy generic mortgages to leave them unhedged, we'd have way too much downside.

So what can we do? We have to continue to focus on insulating our portfolio from headline risks and unexpected changes in policy. On the asset side, this means continuing to focus on prepayment-protected specified pools, which can better withstand prepayment shocks.

On the liability side, it means continuing to hedge along the entire yield curve, trading actively and continuing to make substantial use of TBA short positions. It's that substantial use of TBA short positions which sets EARN apart from the other agency mortgage REITs.

And remember, in the fourth quarter of 2016, during the most volatile quarter for the interest rates since the financial crisis, it was that substantial use of TBA short positions which enabled EARN to generate the only positive economic return in the entire peer group.

As Mike discussed, the Fed's tapering leaves a big hole for private capital to fill. However, since the Fed has always focused its purchases almost excessively on TBAs, we expect that if the mortgage market does come under some pressure, that pressure will be felt mostly acutely on the prices of TBAs, where EARN holds substantial short positions.

So we believe we're more than ready for that. For the specified pools that comprise the vast majority of our assets, institutional demand should remain strong and any increase in supply should be gradual and organic.

As Mark mentioned, we think that the technicals for Agency RMBS are actually pretty healthy through next March. But if we do unexpectedly see major widening, whether from the Fed tapering or otherwise, we would definitely look for buying opportunities at higher net interest margins.

And unique among the peer group, we can take advantage of these mortgage-buying opportunities into two very different ways. We can add assets and leverage, that's the way a mortgage REIT would typically do it. Or if we don't want to add extra leverage, we can just dial down our TBA short position in favor of interest rate swaps.

Slide 16 illustrates one of the ways that we view our leverage and our net TBA exposure. As you can see on that slide, at the very end of the third quarter, we were net short $620 million TBAs.

As a result, even though our gross Agency RMBS exposure was $1.71 billion or 8.7x our equity, our net Agency RMBS exposure, after taking into account our TBA shorts, was only $1.09 billion or 5.5x our equity.

So in terms of our exposure to the agency mortgage basis, that's effectively a reduction of 3.2 turns of asset leverage, which moves us to the very low end of the peer group in terms of effective leverage.

Finally, Lisa mentioned our ATM program. And that has enabled us to raise in a highly cost-effective manner, an additional $13.9 million of equity during the third quarter. And then it's having a further beneficial effect on our expense ratios and on earnings per share.

The ATM is an attractive low-cost path to growth that we can utilize on demand when favorable investment opportunities and suitable market conditions are present. Obviously, our stock price is not currently where it needs to be to be thinking about raising more equity capital. But should that change, we view the ATM program as a preferred avenue for growth as opposed to a larger overnight offering.

In summary, we see our opportunity set in Agency RMBS as strong, especially given Ellington's 22-year history of modeling prepayment risk, rigorous asset selection and successfully hedging in a wide variety of difficult market environments.

EARN's adaptable hedging strategy and asset rotation differentiates us from our peers. We are excited about the opportunities that are sure to arise from the impending policy changes. We like to think of ourselves as an all-weather REIT, able to thrive in a diversity of market environments.

And with that, our prepared remarks are concluded. And I'll now turn the call back to the operator for questions. Operator, go ahead.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Steve Delaney of JMP Securities.

Steve Delaney

Good morning, everyone and congratulations on a really solid quarter.

Laurence Penn

Morning, Steve.

Steve Delaney

Hi, Larry. So a number that jumped out at me in Lisa's remarks was the cost of funds increase in 3 quarter of about 18 basis points to 1.56%. And it would appear that most of that related to the June Fed hike. I'm curious as you look out into first quarter of next year, Mark commented on MBS technicals probably holding up well through then.

But thinking about the looming December Fed hike that, I think, we have to assume, is your position today -- how should we think about starting out in the first quarter, the impact on cost of funds?

How much of that 25 basis points from the Fed, how much is built into repo today? And how much do you think the benefit of your hedging will limit the increase in your current 1.56% cost of funds?

Mark Tecotzky

Steve, it's Mark. So the first thing I would say is that, us, like every other REIT, when you enter into a pay fix swap, you're paying fix on one leg, the order -- on the leg that you receive, you're getting 3 months' LIBOR. So what you see typically is if LIBOR goes up, and we've already had -- since last year and change, we already had 3 or 4 hikes already.

The repo cost go up, but the net cost you're paying on your swaps goes down, right, especially….

Steve Delaney

Correct….

Mark Tecotzky

Curve, so that's why if you look at broadly a lot of the metrics on not just EARN but the other REITs. You haven't seen a net interest margin decay as a function of rate hikes.

Now this month, I know there was some net interest margin compression. But that's because mortgages sort of tightened relative to their hedging instruments. They yield less now relative to their hedging instruments than when they did at the start of the quarter.

But just having the rate hike, most of that is neutralized by the fact that we're paying our repo lenders 3 months' LIBOR, but we're receiving the 3 months' LIBOR from our swap counterparties. So in terms of how much of that is priced into the market now, I think almost all of it is.

And so when people look at roll levels going over year-end, so December, January, will market expectations be that you'll have higher LIBOR levels as a result of the Fed rate hike? Those roll levels are priced to the assumption of higher financing costs.

Steve Delaney

So what is like a 60-day roll in early January look like now on the repo side?

Laurence Penn

Well, you mean on that TBA side?

Mark Tecotzky

Yes. So it depends a lot on the coupon. So some of the coupons that roll the best, it might be 2-month LIBOR minus 20 basis points. They have a funding advantage. And some of the higher coupons, where there's some sort of bad and fast pools out there, depending on what you assume for your TBA assumptions, it can look like -- a lot of the pools we own, they can make 3 or 4 ticks of positive carry versus where the roll trades.

Steve Delaney

Got it, okay. No, that's helpful. I mean, we have heard all year long that basically that repo has been barely efficiently priced, so the market has been fairly liquid and that the spread between 1- and 2-month repo versus 3-month LIBOR has been very beneficial to the mortgage REITs. And it sounds like you still see that today.

Mark Tecotzky

Yes, the key metric we look at is we typically do a 3-month repo, where is 3-month repo relative to 3-month LIBOR. And so that tells us whether the financing costs we're paying to our repo lenders is offset by the 3-month LIBOR lag we receive on our swaps.

And the big benefit for REITs, and you really saw their prices react to this, was with that money market reform, right, where all of a sudden, agency -- you had all this money come out of high-money markets and the government money markets, and the agency mortgage repo is a good asset for the government money market fund.

Steve Delaney

Right. And what percentage of your repo you have that covered by fixed pay swaps would you roughly estimate?

Mark Tecotzky

I think it's something like 60-plus percent. And then another big chunk of it will be covered with TBA shorts, where the roll levels are also highly correlated to levels of 3-month LIBOR.

Laurence Penn

Yes, just a process of TBAs. So if the curve flattens, right, then -- and let's just say, long rates don't move, but short rates continue to go up, you're going to see a -- you'll see a price drop in TBAs as well because mortgages have exposure to the whole yield curve.

So short side, I mean, in an efficient market, that would have just as much of an impact as it would have on the swap side. And I just want to add one more thing. If you look at the Slide 17, it just shows, and obviously there's a table in our earnings release that shows this for 100 basis points as well, but it shows what happens to our portfolio based upon our models in a 50 basis point increase or decrease.

And this is a parallel shift, but -- so I'll say two things about this. Number one is in terms of net interest margin compression in the peer group, in the agency mortgage REIT space, I think that you'll find very few companies, if any, that have this type of relatively equal exposure to a decline and an increase and small numbers at that, especially on an increase.

I think in terms of if you look at our actual performance when rates have moved, and I think there's been some -- even publications by some people that have document this that our estimations of our moves have been closer to what actually happened to our book value than in other cases.

And this is -- and we don't just hedge for a parallel shift, we hedge along the whole yield curve. So if the curve flattens, this type of a graph -- this type of a table should hold as well in terms of our -- what we think our book value exposure is. So I think that to the extent that you're worried about what's going to happen today in net interest margin compression, whether it will be for us or in the peer group,

I think that looking at a table like this will help you get one step of the way there at least in terms of what an impact could be. And we don't think that at least -- it should impact us from a GAAP earnings perspective. But there's no question that from a core earnings perspective, it could have an impact and it has had an impact on us.

Mark Tecotzky

Well, I was just going to add one thing. Q3 was the flattest curve REITs have dealt with in a long time. And in terms of economic performance, it was the strongest quarter in a long time. And the other thing I think is interesting, and Larry alluded it in his prepared comments, that $8-odd billion in capital raises for REITs, common and preferred included.

If you think that translates into $35 billion to $40 billion at least of agency mortgage buying, that's the first 6 months the Fed tapers. So 6 months ago, people were thinking, oh, the Fed is going to taper, who's going to be able to supply, what's going to happen to it?

Well, REITs, which are not -- part of the markets that are $40-odd billion in equity capital or something, they were able to absorb October, and then the next 5 months of net supply is from the Fed.

So I thought that was interesting, that sort of -- in the flattest curve, you saw REITs putting the best performance but also become a much bigger marginal buyer for agency MBS than what they've been in the previous 4 years.

Steve Delaney

No, no question. And we did notice the OAS come in over the course of the summer, the REITs were deploying all that capital for sure. So thank you for the comments, guys.

Mark Tecotzky

Thanks, Steve.

Operator

Thank you for participating in the Ellington Residential Mortgage REIT 2017 third quarter financial results conference call. You may now disconnect your lines, and have a wonderful day.