Ellington Credit Co (EARN) 2013 Q4 法說會逐字稿

Good morning ladies and gentlemen, thank you for standing by, welcome to the Ellington Residential Mortgage REIT Fourth 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 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 pick up your hand set to allow optimal sound quality. Lastly, if you should require operator assistance, please press star zero.

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

Before we start, I would like to remind everyone that certain statements made during this conference call may constitute forward-looking statements in the meaning of the Safe Harbor provisions in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical in nature and can be identified by words such as "believe," "think," "expect," "anticipate," "estimate," "project," "plan," "continue," "intend," "should," "would," "could," "goal," "objective," "will," "may," "seek," or similar expressions or their negative forms or by reference to strategies, plans, or intentions.

As described in 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 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.

Okay. I have with me today on the call Larry Penn, Chief Executive Officer for EARN; Mark Tecotzky, our Co-Chief Investment Officer; and Lisa Mumford our Chief Financial Officer. With that, I will turn the call over to Larry.

Thanks, Jason. It is our pleasure to speak with our shareholders this morning as we release our fourth quarter 2013 results. We appreciate everyone taking the time to participate today. The sequence today's call will be as follows. First, Lisa will run through our financial results. Then, Mark will discuss how the residential mortgaged-backed security 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 website, www.earnreit.com. You can find it right on the home page or alternatively on the presentations page in the For Our Shareholder section of the website. Lisa and Mark's prepared remarks will track the presentation. So it will be helpful if you have this presentation in front of you and turn to page four to follow along.

While you are getting that in front of you, I would like to mentioned that while the full name of the company is Ellington Residential Mortgage REIT, sometimes on this call, we will refer to it just as Ellington Residential and sometimes on the call we will refer to it by its New York Stock Exchange ticker, E-A-R-N. Or EARN.

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

Thanks, Larry and hood morning everyone. In the fourth quarter we had a GAAP net loss of approximately $100,000 or $0.01 per share. This net loss breaks down as follows, we had core earnings of $6.8 million or $0.74 per share. We also had net realized and unrealized losses on our real estate securities of approximately $22 million or $2.39 per share. And we had net realized and unrealized gains on our derivatives of $[50] million or $1.64 per share.

Of course expenses related to the quarterly settlement payments of our interest rate swap are included as a component of our core earnings.

In the third quarter we had net income of $6.8 million or $0.74 per share. And we had core earnings of $5.6 million or $0.61 per share. During the fourth quarter, the average yield on our overall portfolio increased to 3.34% from 3.09% in the third quarter. Consistent with what we have been doing all year, we actively traded the portfolio replacing assets sold with those with higher yields and what we believe are more attractive returns profiles. Market volatility has continued to provide opportunities to do so.

Within our holdings of agency RMBS as measured by sales and excluding principal pay downs, we turned over almost 40% of the portfolio. Quarter-over-quarter our agency yield increased 26 basis points to [3.50]%. This increase included approximately 11 basis points which was related to a catch-up premium amortization adjustment. This adjustment was negligible in the third quarter.

As you know we also maintain a non-agency portfolio. The size of this portfolio is obviously small relative to our agency portfolio, but is has been a great source of return throughout the year and has served to offset at least, partially, some of the volatility and returns that have been present in agencies this year.

Non-agencies mostly rallied in 2013 and we took advantage of the rally by selling assets into it and replacing those assets with other attractively priced assets. During the quarter as measured by sales and excluding pay downs, we turned over 26% of this portfolio.

Additionally, strengthening cash flows in the securities we held impacted yields positively in this portfolio. All in all the average yield for the quarter in our non-agency portfolio increased to 9.01% from 7.84%.

In the fourth quarter our costs of funds, including the cost of hedging with interest rates drop increased 15 basis points to 1.72%. The decrease was related to our interest rate hedges as we lowered the remaining average maturity of our outstanding [flux] quarter-over-quarter.

Our costs of repo quarter-over-quarter remain relatively constant at 39 basis points although we are seeing increased competition from repo counterparties, both large established players and smaller new entrants to the market.

We expected as our existing repo rolls off, we may actually begin to see modest declines in our recent haircuts. Additionally, we continue to increase the number of repo counter parties we transact with.

Our operating expenses including management fees, were 3.3% of average shareholder equity on an annualized basis. Based on our current capital we expect it remain in the range of 3.2% to 3.3%.

We ended the quarter with a total portfolio value just above $1.3 billion down from just under $1.5 billion at the end of the third quarter.

Our outstanding borrowing remains at approximately $1.3 billion and our leverage ratio at the end of December was 7.8 to 1 versus 7.5 to 1 at the end of September.

We paid a fourth quarter dividend of $0.50 per share and combined with our second and third quarter dividends we've paid $1.14 per share for 2013.

I would just like to point out that while our core earnings of $1.47 per share for the same period is meaningfully higher than our dividends paid $1.14 per share, our dividend is not sized based on our core earnings, but rather on our estimate of taxable income.

Generally speaking, we expect that our taxable income will be lower than our core earnings because interest income recognition for tax purposes on premium agency pools generally lag that of GAAP.

Lastly, we ended the quarter with shareholder equities of $167.2 million or $18.29 per share compared to $171.8 million or $18.80 at the end of the third quarter.

I'd now like to turn the presentation over to Mark.

Thanks, Lisa. This was another challenging quarter for agency REIT. Interest rates moved materially and Agency RMBS underperformed their hedges. We ended the quarter at close to the high in interest rates for the entire year. While it was a volatile quarter in many agency REIT's suffered books declines greater than 5% it was not nearly as difficult as the second quarter and MBS started performing better after the taper announcement removed a lot of uncertainty.

On Slide 7, you can see this in two ways. This shows the price standing at 3.5 for the last six months of the year regress versus the 10-year spot rate. The red triangle is the last day of the year and if you look at the blue squares directly below the red triangle, you can see that (inaudible) closed the year about 35 base points higher in price than where they were earlier in the year when 10-year swap rates were around the same level. That was back in September.

All the orange circles were observations after the taper was announced. You can see that they are generally above the regression line. If you look at the amount of selling of Agency MBS as a result of the increase in interest rate measured by either mutual fund outflows or REIT's deleveraging. Selling was not as intense in Q4 as it was at the same interest levels in Q3.

Clarity about the Feds taper plans removed one of the major uncertainties that had created a risk premium at Agency MBS. The strong performance of Agency MBS so far in 2014 is a continuation of this trend.

In 2014, mortgages have outperformed their hedges because there is less uncertainty regarding both the pace and timing of tapering and [mortgages] started the year at very attractive valuation.

Turning to Slide 8. Pool pay ups remain depressed but are starting to show some signs of life. Here you see the pay ups in ticks, on medium loan balance [spanning] forward to the start of 2013. These pay ups used to trade over four points but now they are barely at a quarter of a point. They started the quarter at such low levels it is hard to imagine there being much of a drag on book value any more.

The long view of the slide demonstrate that pay ups remain very depressed relative to a year ago and with good reasons. The financings are very low right now. But flip over to Slide 9 and we can see some signs of life since the start of the year.

The pay ups have participated in this years rate rally and as the tapering continues, the Feds winning support of TBA's expenses specified pools [show that] -- should both hurt rolls and help pull pay ups.

Slide 10. We included this slide in last quarters presentation because it shows just how dramatic this pay up compression has been. You can see from this regression that the pay ups almost seem floored out at current levels. We believe this leaves them a lot of up side and little down side.

Slide 11. In Q4, the Agency MBS markets got clarity on the timing and magnitude of taper, now managers need to assess the likely impact and position their portfolios appropriately. Here we go back seven years and show both the size of the Agency RMBS market and how much was held by the government. The dark blue represents the GSE holdings and the light blue represents the Fed holdings.

So dark blue and light blue together is total government holdings. I think what surprises a lot of people is that government holdings aren't that much bigger than they were in 2009. While the Fed has been growing, Freddie and Fannie have been shrinking. You can think of the first $750 billion or so Fed purchases as coming from Fannie and Freddie.

Going forward we believe the combined government holdings are going to shrink very slowly. Post-taper, the Fed holdings should stay constant and Fannie and Freddie portfolios should run down. You can see investors out side of the government and government sponsored entities have shrunk their agency portfolios by about $300 billion since QE3 started in the fall of 2012. That is the maroon area on this graph getting smaller.

As the Fed tapers, if the market is going to grow in size, capital has to come from private investors who are going to want to get paid to provide investment capital to the agency market.

Turn to Slide 12. So looking forward we think a lot may be different in the summer. The Fed will keep reducing their purchases. So far the impact of the taper has been muted and supply has been so low. We expect a increase in supply in the early summer as a result of seasonal home buyers. We may also get an increase in supplies from loosening credit standards.

The Fed has been the dominant buyer recently and they are the only buyer that probably doesn't care about making a return on their investment. Once they step away, we think other investors will need a bigger differential between specified pools and TBA to incentivize them to buy TBA. So we expect full pay ups to do better.

We know that once the Fed buys at a slower pace then Fannie-Freddie runoff, all additional growths in the market has to come from private capital. At the end of the fourth quarter, we believe that the fundamental bond the agency mortgage market were very sound. Prepayment risk was muted and valuations looked attractive. However, MBS is performing very well so far in 2014 and so we believe the implications for portfolio construction are that we should now less exposed to the mortgage basis. We think that it makes sense that continued exposure to specified pools, some hedge with swaps but now even more hedge with TBA.

In addition, the agency mortgage market is big, liquid, and complex so it offers many opportunities to add excess returns to active trading.

During the fourth quarter, interest rates continued to be volatile, running just a one year gap between assets and liabilities and leveraging that eight times can expose you to a 4% book value decline if rates move 50 basis points a quarter, similar to this quarters move.

In addition, in the past three quarters, we have generally seen mortgages underperform their hedges in rising rate environment which means mortgage underperforming their rate duration in a 50 basis point sell-off could make the 4% decline even worse.

[Annuities] to try to reduce book value volatility like we were able to do in the fourth quarter, we generally choose to be more hedged in our [interest rate] risk and instead we try to add additional returns through active trading. Running with the small interest rate gap rather than the larger one is obviously more expensive for us. To close the gap, we need to have either more hedges or you need to have hedges that are further out on the curve and therefore more costly.

Our goal is to generate attractive returns while limiting book value volatility that comes from [interest rate movements]. Our active management style certainly helps with that approach.

With that, I will turn the call back to Larry.

Thanks, Mark. As you know our mantra at Ellington Residential is that we try to capture the upside in good markets and control the down side in tough markets. In the third quarter which was a reasonably good quarter for Agency RMBS, our fully mark-to-market ROE was around 4% which was substantially better performance than our peer groups.

The fourth quarter however, was much more difficult as the 10-year treasury yield rose from [261 to 303]. And Fannie Mae three-and-a-halves dropped about 2.5 points in price. Despite those headwinds, even on a fully mark-to-market basis, Ellington Residential basically broke even for the quarter with a $0.01 per share loss.

With Mortgage REITs focusing on Agency fixed rate pools, like EARN, it was a difficult quarter. And when the dust settles on earnings season, I think you will find our performance stacks up very well.

So for the three quarters since we have been public, we have outperformed our peer group in each quarter. As you know, we believe that our active trading style is a key factor in our ability to do this.

Meanwhile, we believe that we position ourselves well for 2014. In the fourth quarter, we were able to expand our net interest margin to 2.17% from 1.77% and similarly our core earnings expanded to $0.74 per share from $0.61 per share.

Part of this NIM expansion was due to the slow down of prepayments for our premium agency pools which is boosting their yield. Our agency RMBS prepaid at only 2.2% CPR on average during the fourth quarter as compared to 3.6% CPR during the third quarter. We are extremely pleased with the prepayment performance of our agency portfolio.

I think that Mark made a very convincing case on the compelling value in specified pool pay ups in many sectors. As Mark alluded to Ellington Residential has already enjoyed a nice specified pool rally, so far, this quarter. And we still think there is tremendous value and much more upside in our agency portfolio.

In fact, we believe there are lots of different ways that our agency portfolio hedged not only with swap-based instruments but with significant portion of TBA short positions as well can make money for us.

We feel we're long a lot options that the market is undervaluing. For example, if interest rates drop, the prepayment protection that we bought will become extremely valuable. That is the most obvious option roll-off.

As another example, the prepayment protection we bought can also become much more valuable based on policy decision made by Mel Watt, the new Director of FHFA and the Regulator of Fannie Mae and Freddie Mac. Director Watt has a very different agenda from his predecessor, Ed DeMarco. He has already reversed some of DeMarco's initiatives and more changes may be coming. Director Watt has made it clear that the wants to make it easier for borrowers to refinance, not harder.

As yet another example, if tapering by the Federal Reserve depresses the TBA roll market, not only will our short TBA positions out perform, but Agency RMBS investors may flock to the specified pool market. So our long specified pool positions may outperform as well.

And finally, keep in mind that we are always reassessing the mix between TBA's and swap based instruments on the hedging side. With the Federal Reserve to continue to withdraw its support from the Agency RMBS market throughout 2014, we believe it to be a very interesting and fruitful year for agency strategy, as Mark mentioned, we have already increased our TBA short relative to our interest rate swap short.

We also think that the non-Agency RMBS market will continue to be fertile investment ground for us in 2014, for a number of reasons. The first reason, we continue to like the non Agency RMBS market is that competition from Wall Street banks are declining, as a result of both their lower risk tolerance and the new Dodd-Frank and Basel III regulatory frameworks.

So now when a large portfolio hits the market for sale, or a large buy program comes into the market, the sector moves are much more accentuated than they used to be. And Ellington Residential can take advantage by either buying or selling as the case may be.

Another reason why we continue to like the non-Agency RMBS market is that we continue to see large discrepancies between market sectors. And our views of expected yields and assets can still differ materially from those of other market participants. And importantly, these discrepancies vary over time. So one day, we find ourselves buying one sector when others are selling. And then later, we are selling that same sector when others are buying.

For now, we like the mix between Agency and non-Agency RMBS in our portfolio, especially with all the opportunities we are seeing in the Agency RMBS market. That being said, investors know that Ellington Residential's mandate is flexible. Ellington Residential's allocation to non-Agency RMBS has been relatively small since our IPO but still meaningful and impactful. However, should severe dislocation to non-Agency RMBS market ever develop, Ellington Residential could then significantly dial up its exposure in non-Agency RMBS.

This concludes our prepared remarks. Operator?

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

Thank you. Our first question is coming from Steve Delaney with JMP Securities.

Thanks, good morning everyone and congratulations to a strong close to the year. I was really impressed by the CPR data on page 16, so I would like to start with that. So, obviously, when you buy the pay ups and the loan balance and the HARP pools, you are going to expect lower prepayments, which is why you buy them. What I am wondering, and we saw the benefit to poor APS and net interest income with just the modest drop from 3.4% to 3.6% on your loan balance pools.

Here is what I am asking. Let's talk seasoning, if we are looking out a year or so over the next four to six quarters with this $700 million and some of loan balance pools. Despite light shifts in rates from quarter to quarter and actual refi activity, is there some sort of seasoning that we should expect as these pools age a little bit and we just have property turn over. People move, people get divorced, et cetera. I am just trying to think longer term where this CPR might go, thanks.

Hello, Steve, it's Mark. That is a good question and there is actually a lot of trading now going on in pool as a function of their loan age. In particular in the discounts, so we have been active in some of the 3% pools that have some seasoning to them, where there is a particular combination of attributes that have them prepaying faster than other pools.

And what is interesting is that it gives you a little bit of a yield pick up there because they are at a discount, but the main benefit is it shortens the duration so they can up your hedges a little bit shorter on the curve which is less expensive. You know it is with the help of the NIM on some of that stuff.

I think seasoning is a big deal, in particular, a lot of the pools that were created in 2012 had a very large number of the loans came out of a refinancing. So a lot of low pools were created in 2012, the borrowers that were in the house since 2006 and 2007 and you are starting to see over time you see life events that are catalysts for people to move. They need an extra bedroom or they have too many bedrooms so they want to downsize a little bit. I think that story and that phenomena is going to be a bigger and bigger deal.

So you will definitely see -- so you should see some of this higher coupon pools as they season, they will pick up a little bit in speed as them come along the seasoning ramp. But in a lot of instances that almost makes them more valuable because the seasoning shortens their duration a little bit, which allows you to have your hedge on a little bit shorter part of the curve.

As those events occur, do you sort of have an expectation like where these could max out. Is it upper single digits, or 10 CPR These pools, I assume, you never expect these to pop up to be 15 or 20 CPR kind of pools?

I would say for the low loan balance, if you get them enough in the money, you can see those kind of speeds. But I think given where the forward curve is it projects a lot of things not having significant weight incentive going forward. So I think, yes.

Right now, we are six to seven CPR is faster than what we are currently seeing on turnover. But part of it is right now we are in the seasonal trough. So I think you can definitely get there on pools.

Right. Okay, thanks.

Steve?

Yes, Larry?

Let me just add at the risk of getting into the weeds on GAAP accounting on pools. At the risk of both boring people and getting outside my area of expertise. Let me just say that the way our yields are calculated, Lisa will correct me if I make a mistake, is the yields that we recognize interest income at are calculated at using a blend, if you will, of the speeds that we have seen so far in the pool but by far and away the most important factor is the speeds that we project.

So the slow speeds, obviously have a good affect on interest income in terms of less pay downs coming in, they also increase a yield based on that blended calculation between the history and the projection. The projection, of course, dominating since it is so much further into the future.

So that has a small effect so far, the fact that speeds have been slow, but as Mark mentioned, by far and away, the more important characteristics where you really see the CPR differentials between our pools, we believe, and the generic pools in the market, if and when rates drop.

And I appreciate that because I was actually going to segue into a question for Lisa given how strong core was relative to the dividend. And I appreciate the full year numbers that you shared with us, Lisa. Could you give us a brief explanation of the difference between GAAP and tax in terms of premium amortization? Is tax more like some type of level yield while GAAP is more you are realizing the benefit of actual short term speeds?

Right, so GAAP like Larry said, looks at history and it looks forward in terms of our prepayment expectations. And it will cause adjustments in our interest income because of the squeeze adjustments. The basis adjustments that we described which was 11 basis points or $400,000.

Tax is much more level, it uses factors to calculate interest income and when you have premium securities like these agency pools, it's significantly slower than -- or the amortization is actually faster on a premium pool under tax than GAAP.

And one reason is that the agencies publish these what are called market discount factors that you are supposed to use or you can use an election to amortize your market premium, which is of course, these pools are actually issued at par, right. Ultimately, when they are originated, the homeowner is getting par, but the agencies compute when the pools originate at a speed, essentially, a speed for the pool that they project and then that drives the tax calculations actually forever.

It does not change.

It is the same speed pretty much. So the tax authorities decided that you are supposed to use the so called issuance speed, it has been the case for many, many years now since really REMIC started. So that is why their speed assumptions are quite a bit higher on the premium pools than GAAP sort of has you do and therefore, as Lisa said, higher speeds, higher premium amortization, less taxable income.

(Operator Instructions) And at this time, it appears we have no further questions and I would like to turn the floor back over to management for any additional or closing remarks.

I want to thank everybody for participating on the call and we will see you again next quarter. Thanks very much.

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