Ellington Credit Co (EARN) 2013 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT Second Quarter 2013 Financial Results conference call. Today's call is being recorded.

At this time, all participants have been placed in listen-only mode and the floor will be open for your questions following the presentation. If you would like to ask a question at that time, please press star one on your touch-tone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. We ask that you please pick up your handset to allow optimal sound quality. Lastly, if you should require operator assistance, please press star zero.

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

Before we start, I would like to remind everyone that certain statements made during this conference call including statements concerning future strategies, intentions and plans may constitute forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are not historical in nature and can be identified by words such as "believe," "expect," "anticipate," "estimate," "project," "plan," "should," or similar expressions or by reference to strategies, plans, or intentions.

As described in Exhibit 99.1 of our quarterly report on Form 10-QK, filed on June 11, 2013, forward-looking statements are subject to a variety of risks and uncertainties that could cause the company's actual result 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 with me today on this call Larry Penn, Chief Executive Officer of Ellington Residential; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford, our Chief Financial Officer.

Thanks, Sara. It's our pleasure to speak with our shareholders this morning as we release our second quarter 2013 results. We appreciate everyone taking the time to participate today on this, Ellington Residential Mortgage REIT's first earnings call.

The sequence for today's call will be as follows. First, Lisa will run through our financial results. Then Mark will discuss how the MBS 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 reminder, we posted a second quarter earnings conference call presentation to our Web site, www.earnreit.com, that's E-A-R-N-R-E-I-T.com. You will find it right on the Presentations Page in the "For Our Shareholders" section of the Web site. Lisa and Mark's prepared remarks will track the presentation so it would be helpful if you could have this presentation in front of you and turn to page four to follow along.

While you're getting that in front of you, I'd just like to mention that while the full name of the company is Ellington Residential Mortgage REIT, sometimes in this call, we will refer to just as Ellington Residential and, sometimes on the call, we will refer to it by its New York Stock Exchange ticker, EARN, or just Earn.

Hopefully, you now have the presentation in front of you and opened to page four. And with that, I'm going to turn it over to Lisa.

Thank you, Larry. Good morning, everyone. For the second quarter, as you can see in the presentation, we recorded a net loss of $9.7 million or $1.55 per share. The net loss is comprised of the following components, net interest income and net realized and unrealized gains on derivatives of $40.5 million, offset by net realized and unrealized losses on our RMBS securities of $488 million and expenses of $1.4 million.

Income from our hedges offset approximately 75 percent of our net realized and unrealized gains on RMBS assets. We ended the quarter with book value per share of $18.57 as compared to $19.55 at the end of March, representing a decline of 5.5 percent.

As you know, we completed our initial public offering in May along with a concurrent private placement. The IPO and the private placement resulted in net proceeds of $148.5 million. We ended the quarter with total shareholders equity of almost $170 million.

Similar to other mortgage REITs, many other mortgage REITs, we will report core earnings each quarter. Core earnings is a non-GAAP metric and represents our net income less the impact of realized and unrealized losses on our RMBS assets and derivatives.

Core earnings does include the impact of the net periodic expense that we incur for our interest rates swaps. For GAAP, this cost is included as a component of realized and unrealized gains and losses on derivatives.

On that basis, our core earnings for the quarter was $1.3 million or 21 cents per share. Our reconciliation of net income to core earnings appears on Slide 22 of the presentation.

Our net interest margin for the quarter was 1.63 percent, which was derived from the weighted average yield on our assets over the quarter of 2.82 percent, less our weighted average borrowing cost including our interest rate swaps of 1.19 percent. As of the end of the quarter, our net interest margin was essentially the same. We expect our expense ratio on an annualized basis will approximate 3.3 percent.

We ended the quarter with 1.35 billion in RMBS Holdings, 1.3 Billion in agency RMBS, and just under 40 million in non-agency RMBS. As of June 30th, our agencies are comprised of fixed rate mortgages, predominately 30 year securities with underlying fixed rate mortgages.

We had repo borrowings outstanding of $1.26 billion at the end of June. And even though we technically didn't finance any of our non-agency holdings, based on our internal measurement of risk capital and liquidity at the end of June, about 85 percent of our capital was in support of our agency strategies and 15 for our non-agency strategies.

In terms of our hedges, as of the end of the quarter, we had interest rates swaps and TBAs outstanding, and you can see this on Page 18 of the presentation. Our interest rates swaps had a notional value of $781 million and our net TBAs had a net short notional value of $346 million.

We've been using longer-dated interest rate swaps, which has been much more effective hedges than shorter dated swaps in the current climate. Our short TBAs are obviously helpful in hedging basis risk in addition to interest rate risk and they are an important component of our hedging strategy.

We declared a second quarter dividend of 14 cents per share, which was paid in July. This dividend was based on our estimate of core earnings at the time and was based on a partially ramped portfolio. By the end of the second quarter, however, we considered the portfolio to be fully ramped.

I will now turn the presentation over to Mark.

Thanks, Lisa. So on slide seven. At this point in the mortgage REIT earnings cycle, there has been a lot of information about the underperformance of agency MBS in the quarter. So as opposed to just summarizing, I've tried to show pictorially some of the challenges since we launched in early May. And then I'll talk about how we tried to mitigate the risk.

This slide shows the price performance of 30-year Fannie threes, 30-year Fannie three-and-a-halfs, the 3-year treasuries and the 10-year treasury. I've normalized all these prices to 100 for the day EARN went public.

You can see the Fannie threes in the 10-year note, the two lines at the bottom of the page were each down about 8 percent. But in early May, Fannie threes traded over $104 price and the market was treating them with five- to six-year duration. While meanwhile, 10-year note had about nine years of duration. So this 8 percent downward move in the 10-year note should have implied about a 4 to 5 percent downward move in Fannie threes. For them to be down 8 percent was a material underperformance.

Now look at the top, now look at the line on top. This is the price change of the 3-year note. And as a REIT, it's very tempting to hedge a lot of your interest rate risk in the front end because rates are much lower there, so that was supportive of a higher NIM. But the 3-year note had almost no hedging value because it has been largely anchored by the Fed.

Shortly after we went public, the Fed essential reintroduced interest rate uncertainty back into the market, so it was critical to hedge across the yield curve in a way that matched your assets as opposed to being tempted to just concentrate your hedges in the front end of the curve.

You also see on this slide that Fannie three-and-a-halfs had a similar fate. They dropped 6 percent. In early May, they had less than half the duration of the 10-year note, but they dropped 75 percent as much. Part of what was going on is that this rates increase, prepayment expectations slowed. And as prepayment expectations slowed, these bonds extended in duration. And when the bonds extend out, they extend on a very steep yield curve, and the belly of the yield curve, between three and seven years, there was a 30 to 40 basis point increase in yield for each one year in the swap curve.

Now look at Slide 8. This slide shows how much the duration moved on Fannie three-and-a-halfs since May1st, basically from a 4-year security to almost a 7-year security.

So let's put this in perspective. On the date of EARN's IPO, the 4-year swap rate was 60 basis points. By the end of the quarter, the 7-year swap rate was 215 basis points. So while no part of the swap curve moved 100 basis points, you can see the hedging [cost] the Fannie three-and-a-halfs could have increased by 155 basis points.

So while MBS are a lot wider in spread terms and, in particular in what we call option-adjusted spread, the terrible price performance won't translate dollar for dollar into higher NIM because some of the price declines were not at all related to yield spread widening. In spread, some of it was durations extending on a steep curve.

So what are the main ways you can mitigate that risk -- dynamic hedging, TBA shorts and options. I think it is a big mistake to sit with a static portfolio and not manage it over the cycles.

So what's the good news? There is dramatically less extension risk in the market than there used to be. And for a REIT, mitigating the risk was critical in the quarter. Dynamic hedging, that meant adjusting your hedges as the market is moving, not after it has moved.

Prudent use of TBA shorts. Short positions in TBAs automatically extend in duration in a sell-off up into control and to save risk and swap [rates].

What we did to control book value to clients was to gradually increase our MBS exposure, keep a healthy amount of TBA short, and dynamically change our interest rate hedges throughout the quarter.

Slide 9, prepayment risk. People haven't been talking a lot about this but I think it's a really big deal and it makes quality of the NIM now much stronger than a few months ago. For many coupons, prepayment risk is completely off the table for at least a 50 basis point move. And we can now buy a much bigger range of coupon without having to pay multipoint pay-ups for a call protection on a specified pool.

The Day One NIM on a pool with great prepayment protection, is lower than a pool with lousy prepayment protection. So just knowing the NIM isn't enough. Today, the NIM you are able to generate can be robust for a broad range of rate moves without having to take a lot of payoff risk. And pools with big pay-ups tend to be less liquid. So being able to buy quality pools at low pay-ups is one very favorable aspect of the market right now.

So you can see from this graph that the refi index has plummeted. The other consequence of this is that origination volume is way down so there's a lot fewer pools that originators are selling into the market.

Let's look at the portfolio. Slide 11, so this is where we are. While we look [ramped] up, we are in some ways, and in some ways there is still a lot to be done. As we start ramping up the portfolio when the market started selling off, we had a view that pay-ups could come down. So we bought some pools that are very modest pay-ups to TBAs in expectation as pay-ups dropped, we would sell those initial purchases and rotate into pools with more favorable attributes. We have been working on that portfolio rotation and it remains ongoing. We have also been getting more involved in both the 15-year market and adjustable rate mortgages, which are starting to look more interesting to us.

Slide 12, here are some more stats on the portfolio. As pay-ups for loan balance pools dropped since our IPO, we have been buying more of them.

Onto slide 13, so here is a non-agency portfolio. It's mostly all (inaudible) jumbo [A] products. We've had a preference for some lower-dollar priced securities where you can get the benefit from an improving housing market.

Slide 15, the borrowing. So over time, we expect our counterparties -- we expect to increase our counterparties and probably increase our [days] to maturity.

Slide 16, [interest rate] hedges. Two things to note here -- we have kept a core TBA mortgage hedge while the market has been volatile and you have seen aggressive mortgage selling as some investors deleverage. Another important takeaway, and Larry mentioned this, is that we have a lot of our rate hedges on the longer part of the curve.

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

Thanks, Mark. As many of you already know, we brought Ellington Residential Mortgage REIT to market because we believe that there are and always will be excellent long-term opportunity in the residential mortgage-backed securities market.

Most of you know that we already manage another public company, Ellington Financial, who we sometimes refer to by its ticker, EFC. On this, our first earnings call for Ellington Residential, to clear up some possible confusion, I just wanted to start by highlighting the two main differences between Ellington Residential and EFC.

First, EFC is not a REIT but rather a publicly traded partnership, and Ellington Residential is of course REIT. Second, while EFC deploys most of its capital in mortgage and asset-backed credit focused strategies, Ellington Residential deploys most of its capital in agency RMBS. Namely, Fannie Mae, Freddie Mac and Ginnie Mae mortgage pools. So at the risk of being overly simplistic, Ellington Residential is almost the flip side of EFC as far as where it deploys its capital.

Now when we brought Ellington Residential to market, we knew that the REIT model is one that continues, for good reason, to be very popular with investors. In addition, the agency MBS market, which other than the U.S. Treasury market, is the deepest and most liquid U.S. fixed income sector, it's also something that investors have a basic understanding of and long history and comfort with.

Now while the REIT model imposes some constraints on portfolio management in general, and on hedging in particular, the constraints aren't too burdensome on us in the case of Ellington Residential. Since as an agency RMBS focused REIT, the primary risk we need to manage is interest rate risk, and the REIT model actually allows robust interest rate risk management.

Ellington Residential's objective is to deliver attractive dividend yields over market cycles while mitigating risk, especially interest rate risk, and all in the form of an agency focused mortgage REIT. The agency pool market is one of those ideal markets combinations of high liquidity, agency pools trade with a bit offer spread of just a couple of [30 seconds], and high complexity. Just look at all the different flavors of specified pools out there, each one with its unique and highly complex prepayment characteristics, not only involving interest rates but involving geography, loan balance, loan to value, FICO credit score, et cetera. We have a slide showing all the different types of pools that we've invested in.

This makes it a great market for us. The liquidity of the market allows us to very actively manage the portfolio. The depth and breadth of this market allows us to be extremely disciplined about just what kind of pools we choose to be invested in at any given time. And the complexity of this market allows us to apply Ellington's extensive expertise in prepayment and interest rate modeling and analysis.

So while Ellington Residential's goal is to perform over market cycles, little did we know when we priced our IPO on May 1st that we were about to face the toughest two-month period for agency mortgage REITs since the depths of the 2008 to 2009 financial crisis.

Now, we're not happy to say the least that we've lost money for our investors so far, but Mark Tecotzky and his team actually did a superb job under extremely difficult market conditions keeping our book value decline to just 5.5 percent.

Although Ellington Residential was less than two weeks old when all this started, it of course was able to leverage management's decades of experience trading these securities. Management has been talking for years about the importance of hedging over the entire yield curve, as opposed to just hedging, say, the short-end of the yield curve, about the importance of hedging dynamically as interest rates move, and about the importance of being able to hedge agency pools with short TBA positions, and being able to dial that short TBA exposure up and down depending on market conditions.

Management's use and experience were put to the test right out of the blocks for Ellington Residential, but we just stuck to our core principles and remained extremely disciplined about each of these things -- hedging across the entire yield curve, rebalancing our hedges with each drop in rate, dialing up and down the short TBA exposure. And as a result of this discipline, we were never under any pressure to sell any assets.

When you look at what happened to the book value of other agency mortgage REITs during the quarter -- and which, by the way for those other REITs, included what was actually a pretty strong April for agency pools -- many of these REITs losing 10 percent, 15 percent, or more in book value, I'm sure you'll agree that our performance actually stacks up extremely well.

And importantly, there are lots of silver linings here. Agency pools offer terrific value here. Prepayment and policy risk has gone down as rates have risen, and meanwhile spreads are actually wider. In fact, we could make back more than half of that 5.5 percent book value loss with just a 10 percent basis point tightening in MBS yield spreads.

Furthermore, our competition for asset is noticeably lower now than it's been in a long time. And we still have dry powder.

So while this was a difficult quarter for us, the market move has created many opportunities going forward. We believe as strongly as ever in our approach and our strategy. We hope to continue to differentiate ourselves, not just by controlling downside in bad markets as we did this past quarter, but by capturing upside in the good markets that will inevitably come.

This concludes our prepared remarks. Before I open the call up for Q&A, I would just like to point out that we'll be happy to respond to questions the extent that they are directed to matters related either specifically to Ellington Residential, or more generally to the RMBS market in which it operates. We will not be responding to questions on Ellington's Private Fund or other activities.

Operator?

The floor is now open for questions. (Operator Instructions)

Thank you. Our first question comes from the line of Douglas Harter with Credit Suisse.

Thanks. In your prepared remarks, you referenced having some dry powder. Could you maybe expand upon that and let us know where you would feel comfortable taking leverage to, you know, in this type of environment or? Thank you.

Sure, yes. I'd rather not quantify it in, you know, actual dollar terms. But, you know, I think in a normal -- in a market environment with sort of our typical mix of, let's say, where we are now, roughly 85 percent, you know, of our capital deployed in agency and 15 percent in non-agency, you know, I think we would be comfortable taking that leverage closer to, let's say, a little under eight times on an average basis, especially now we're at 7.2. So maybe a little more than another half a turn of leverage.

You know, I think one of the reasons that we have kept a slightly lower average now than we originally had thought we would was two fold. Number one, just to, you know, recognize the fact that this is a very volatile market and, you know, it's just more prudent to keep your cash balance a little higher. And then second, you know, just the fact that in a market environment like that, some great opportunities could all of a sudden come along and you want to have the flexibility to pounce on that. But longer term, I could see us, ourselves, increasing that half a turn or so.

Thanks. And then can you talk about where you're comfortable running your net duration right now? Or sort of your book value at risk to rises in rates?

I mean, we don't -- in terms of having an outright duration bet, that's something we just try to avoid. I mean, our edge, if you will, is, you know, not forecasting where rates are going but other things.

So, we will allow ourselves to be, you know, short some convexity, so that's not to say that we don't have interest rate risk but we try to stay pretty close to home. You know, I say we try to stay less than a year in duration, or about a year in duration, no more than that, as far as what just the outright duration of the portfolio is.

Our next question comes from the line of Steve Delaney with JMP Securities.

Morning, everyone. Thanks for taking my question. And Larry, I think just before I ask my question, you know, I'd like to just note, you know, you priced your IPO on May 1. The Fannie Mae three-and-a-half was 106.6, I think pretty much a recent high, and closed June 30 at 101.5. So in that context, I think down 5 percent on BV was pretty darn good. So, congrats to your team.

I wanted ask -- we're going to start modeling your book value now based on the 6/30 portfolio and hedge information. I guess the question is sort of general. You look to be pretty well hedged up. I mean, if we look at swaps to net MBS, it's about 82 percent and, you know, I think we're probably reasonably -- even though we're just looking at notional, we're probably close to being somewhat duration matched up there.

Do you feel that the portfolio you had at 6/30 versus where we sit today in mid-August, did you have the portfolio pretty much where you wanted it from a risk standpoint? And if you could answer that first.

And then secondly, I know you mentioned in the press release adding securities. You know, could you comment on the securities you've added versus hedges. Is the construct of the portfolio reasonably similar today as what we had at June?

Well, I mean, so let me say that, from a hedging perspective, we do try to stay, as I said, you know, close to home from a duration perspective. We do mix the TBA versus the interest rate swap; that's something that will change dynamically over time. So I don't want to lead people to believe that what you see at June 30 is necessarily what we'll have, you know, any point over that. These are very liquid markets and we can maneuver those, make those maneuvers quickly and sometimes you need to. You know, roles expand and collapse. The relative value of mortgages versus swaps changes. So that is something that moves a lot.

In terms of the asset side of the portfolio, we have been in the middle of a rotation. And so what I would say is, if you looked at that pie chart in terms of, on June 30, which types of specified pools we were in, again, you know, this is a liquid market and, as we've been mentioning a lot of the prepayment protection stories have gotten a lot better. And, you know, especially where you need it the most, which is in the higher coupon, in terms of gotten better in term of where they are priced. You can buy them very cheaply now.

So Mark, do you want to add anything to that? You know, I can't give too much detail but I will tell you that that -- those are the themes that have been going on since June 30.

I understand. And I had -- go ahead, Mark, please.

Hey Steve. I would just add that there are a lot of types of pools used to trade up three points over TBA, you know, basically all this year until, you know, June. And we had a bias against those things because that incremental pay-up is very hard to hedge and it makes things less liquid.

Now, a lot of that stuff, stuff that -- you know, pools that used to trade up a point and half, that can get up six ticks. Pools that used to trade up three points, you can get up 5/8th of a point.

So, you know, I mentioned in my comments, we bought some sort of like -- almost like placeholder pools when we started because we thought pay-ups could come down as the market started selling off. So we've been selling out of those and buying in the pools that pay-ups have gone from three points to, you know, three-quarters of a point. Because I think the Fed definitely introduced rate uncertainty into the market, you know, with their comments, since we started EARN. I think things can go both ways, right? Like there are a lot of things now being priced as though rates can never drop and maybe that will happen, but you can get this insurance so cheap now that I think it makes sense to do it.

So there's that, then there's --

That's where I was going, Mark. I mean, you were -- you're 80 percent spec pools, but within that, you were 50/50 between loan balance and HARP. And just looking at the data we have tracking pay-ups, I'm a little surprised that it looks like to me that the HARP pools, the CQs, are a lot cheaper than the loan balance pools. So, are you seeing that as well?

Yes, so those CQs, you know, they have a different duration profile.

Mark, you want to explain what those are?

Yes, so for other people on the call, the CQs are pools that have an initial LTV between 105 and 125. But as opposed to loan balance, they're not deliverable into TBA. So, because of that, they have a longer duration than a loan balance pool, which you might not see on model, but that's how they behave in the market, because the model doesn't know about sort of TBA puts.

And, yes, we have exposure to CQs, and CQs have been extremely volatile. You know, we will -- I wouldn't go full board to CQs because that extra duration they have in a selloff, you need to hedge for it, right? And any extra duration on the swap curve, it's expensive to hedge. You've got to be getting at least another 20 basis points in the CQs, I think.

So, yes, we have them and I agree with you, they've definitely gotten cheap.

And by contrast, you're saying the loan balance pools, are they generally deliverable in the TBA market?

Yes, they're all deliverable.

(Operator Instructions)

Our next question comes from the line of Jim Young with West Family Investors. Jim, your line is open.

That question has been withdrawn.

Our next question comes from the line of Charles Huebner with Pointe Capital Management.

Mark, I was going to just ask -- I think in your presentation you talked about how you initially were willing to pay a bit a premium for paper. But generally, is the target to try to limit your prepayment risk by keeping the average cost of your portfolio at or below par?

No, I wouldn't say that. We look at range of coupons -- 30-year, 15-year, then the hybrid space -- and just try to find what we think is the best, you know, best attributes that's going to give the best total return, the best net interest margin. So the discount securities, those are the ones that bore the brunt of the selling in the second quarter. So those securities probably cheapened up, probably are looking at things a little bit more than some of the higher coupons.

But we look across the curve, you know. And so when you're in the discount securities, you're almost -- it's almost like standing on your head there sometimes. You're looking at the securities you think are going to -- you are looking for securities, you're going to prepay a little bit faster, which helps your yield and it shortens your duration a little bit.

But to Larry's point, I think it's a good one, that there is such a rich range of opportunities between loan balance, HARP, credit scores, geography stories, pools at 107, pools at 95, you can really try to hunt around and pick what's going to have the best long term returns. And that's what we try to do. So, you know, the market dynamic and we try to be dynamic in response to that.

That was our final question. And I'd like to turn the floor back over to Larry Penn for any additional or closing remarks.

Okay, no. Just thank you, everyone, for participating on this, our first earnings call today. And enjoy the rest of your summer. And we look forward to speaking with you all next quarter.

Ladies and gentlemen, this concludes Ellington Residential Mortgage REIT Second Quarter 2013 Financial Results conference call. Please disconnect your lines at this time and have a wonderful day.