Ellington Credit Co (EARN) 2014 Q1 法說會逐字稿

Good morning ladies and gentlemen. Thank you for standing by. Welcome to the Ellington Residential Mortgage REIT first-quarter 2014 financial results conference call. Today's call is being recorded. (Operator Instructions). It is now my pleasure to turn the floor 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 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, 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 our annual report on Form 10-K filed on March 21, 2014, forward-looking statements are subject to a variety of risks and uncertainties that could cause the Company's actual results to differ from its beliefs, expectations, estimates and projections. Consequently, you should not rely on these forward-looking statements as predictions of future events. Statements made during this conference call are made as of the date of this call and the Company undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events, or otherwise.

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

Thanks Jason. It is our pleasure to speak with our shareholders this morning as we release our first-quarter 2014 results. We appreciate everyone taking the time to participate today.

While in the first quarter the bond markets were relatively calm compared to recent quarters, as usual we were quite active at Ellington Residential and we were profitable in both our agency and nonagency portfolios. Our higher coupon agency specified pool portfolio which we carefully built and diligently enhanced over the latter part of last year has performed very well and we think it still has a lot more upside potential. As a byproduct of our active trading style and our constant desire every day to upgrade our portfolio, our overall net interest margin increased to 2.34% from 2.17% at year-end. And as a result, we increased our quarterly dividend by 10% from $0.50 to $0.55. Looking forward, as you'll hear from Mark, we feel that the market may have gotten a little complacent here and we are committed to be ready to capitalize on any fallout should volatility resume.

We will follow the same format as we have on previous calls. First, Lisa will run through our financial results. Then Mark will discuss how the residential mortgage-backed securities market performed over the course of the quarter, how we position 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 have posted a first-quarter earnings conference call presentation to our website, www.earnREIT.com. You can find it in three different places on the website, on the homepage, on the for our shareholders page or on the presentations page. Lisa and Mark's prepared remarks will track the presentation, so it would be helpful if you have this presentation in front of you and turn to Slide 4 to follow along.

As a reminder, we sometimes refer to Ellington Residential by its New York Stock Exchange ticker, EARN for short. Hopefully you now have the presentation in front of you and opened to Slide 4. And with that, I'm going to turn it over to Lisa.

Thank you Larry. Good morning everyone. In the first quarter, we had net income of $2.8 million, or $0.30 per share. Our net income for the quarter was composed of core earnings of $7 million, or $0.77 per share, net realized and unrealized gains on real estate securities of $14.6 million, or $1.59 per share, and net realized and unrealized losses on our interest rate hedging derivatives of $18.8 million or $2.06 per share. As a reminder, we include the net periodic costs associated with our interest-rate swaps as a component of core earnings.

Of course long-term interest rates dropped over the course of the quarter so it's not surprising that we had gains on our assets and losses on our interest-rate hedges. By contrast, in the fourth quarter of 2013, we had a net loss of $124,000 or $0.01 per share and core earnings of $6.8 million or $0.74 per share. The 3.6% growth in our core earnings per share was due to a decline in our cost of funds and an increase in the yield of our assets.

With respect to our cost of funds, we have seen a decline in the cost of repo financing as old and new dealers alike have displayed an increased appetite to provide retail backed by agency RMBS, which has increased competition among them and consequently lowered financing rates. In addition, as interest rates fell during the quarter, the cost of our interest-rate swaps declined even though we extended the overall maturity of our swap book. Overall, our cost of funds declined 3 basis points to 1.14% over the quarter. Quarter over quarter, our average borrowed funds was roughly the same at $1.3 million.

While interest income was relatively flat quarter over quarter at approximately $12 million, the average yield on our overall portfolio increased to 3.48% from 3.34% in the fourth quarter. Included in the 3.48% is a catch-up premium amortization adjustment of approximately $253,000, representing 7 basis points of the 3.48%. The catch-up premium amortization adjustment reflects the fact that prepayments remained low during the quarter, thereby stretching out the recognition of the premium we paid to acquire our specified agency RMBS pool. In the fourth quarter, the catch-up premium adjusted was approximately 11 basis points. Excluding the adjustment, the average yield on the overall portfolio increased to 3.41% during the first quarter from -- I'm sorry, 3.23% during the fourth quarter and our net interest margin increased to 2.27% from 2.06% in the fourth quarter.

We actively traded the portfolio within our holdings of agency RMBS as measured by sales and excluding principals paid down, we turned over approximately 44% of the portfolio. Our nonagency portfolio is also actively managed although turnover there was relatively low for us at 17% during the first quarter.

During the quarter, our average yield on our nonagency portfolio increased to 10.4% and 9%. We ended the quarter with a total RMBS portfolio valued at just above $1.3 billion, essentially unchanged from the fourth quarter. As I mentioned earlier, our outstanding borrowings were also little changed at just under $1.3 billion. Our leverage ratio at the end of March was approximately 7.8 to 1, also unchanged from the end of the fourth quarter.

We declared and paid a first-quarter dividend of $0.55 per share which represents a 10% increase over our fourth-quarter dividend. The increase in our quarterly dividend is related to the high net interest margin we are capturing as compared to last year.

Lastly, we ended the first quarter with shareholders equity of $165 million, or $18.05 per share, a decline of 1.3% from $167.2 million, or $18.29 per share, at the end of the fourth quarter. However, our economic return on book value was 1.7%. Economic return adds back dividends to ending book value per share and compares that amount to book value per share as of the beginning of the quarter.

I will now turn the presentation over to Mark.

Thanks Lisa. The change in our investors and pricing of the agency mortgage market quarter over quarter was substantial. It's not that prices moved so much. It's the way investors view the risk versus reward that's changed. Towards the end of last year when agency mortgages were so stressed, we reduced our mortgage hedges in favor of swap based hedges and that served us well. After nearly six months of anticipation about the logistics and consequences of the Federal Reserve's tapering of its QE3 buy program, in the first quarter of the year, investors could finally see the market reaction to the taper. There was a collective sigh of relief by market participants when it became clear that there was more than enough demand for agency mortgages to take the place and produce Fed buying. And this feeling of relief manifested itself in many ways.

Look at Slide 7. Back in 2013, the market was fearless about interest-rate volatility and it got a big scare last summer when the Fed talked about taper. But now that we are halfway through the taper, the market once again seems unconcerned about rate volatility. We looked to our market in the second half of last year as doubt of the Fed's ability to taper without causing substantial dislocations to a market that is now convinced the Fed can orchestrate a wide path out of QE without causing any turbulence. You can see that in the swaption pricing. The drop in both realized and implied volatility benefited the parts of the mortgage market like RMBS priced at moderate premiums to par that are short the most volatility.

When people talk about negative convexity MBS, they're basically talking about their exposure to short-term volatility. This has been an amazing change in ,sentiment given its most interesting parts of QE3 taper have yet to come. That will come late summer when the net supply of agency MBS finally exceeds Fed purchases and private investors rush to put capital into the mortgage market as opposed to taking it out, which has been the experience over the last year.

For the quarter, the mortgage market was supported by three powerful forces. First, interest-rate movements in the quarter were limited and the inherent negative convexity of agency mortgages was not a drag on performance. And as you saw in the slide, expectations are for continued limited rate moves. Total prepayments were very low, uneventful and easy to anticipate. And thirdly, net new origination of agency mortgages were surprisingly low.

For investors that don't protect themselves from interest rates, it was a great quarter. We of course managed the portfolio to protect investors from rising rates across the curve, which obviously protected book value tremendously last year and now we have a market where we are able to hedge our mortgage investments with much lower yielding swaps since the start of the year.

To show just how low production in the mortgage market is, look at the next slide, Slide 8. New pools in the mortgage market come from refis, existing home sales and new home sales. On this graph, we normalize existing home sales, new home sales, and the refi index all back to January 1999 levels. All three are at or near generational levels lows. So against this backdrop of low supply, Fed volumes over the quarter was really impactful. We expect things to look modestly different next quarter with all these time periods coming up off these loans.

On the demand side, the modest reduction in Fed purchases was easily met by other participants. CML activity remains steady, fixed income mutual flows turned positive after abstention outflows in the third and fourth quarter of 2013, and pension funds and insurance companies both put mortgage money to work in 2014, reallocating some of their capital out of stock into bonds after the stock market's strong 2013 performance. Despite the very low level of prepayments, much of the capital sold at specified pools, we saw certain sections of the pool market trade very well.

Slide 9. This is a graph of pay up on one of the less liquid parts of the pool market. Fannie Mae CQ pools, which consist of certain higher LTD loans originated under the Making Homes Affordable Program. These pools do not qualify for delivery into TBA contracts. They can take you either above or below the comparable TBA coupon depending on market conditions.

Last year, these pools left in creating almost 1 point over TBA to more than 1 point below to TBA and you can see that since the beginning of the year they have appreciated in price relative to TBA by almost a point. So why is that? It's not because of prepayment periods. It's a lot of other reasons. Some of these pools have a yield pickup versus TBA. Some of them look like they have a lot higher turnover speed relative to TBA.

I guess the larger point is that despite lower overall interest-rate volatility, there has still been some very interesting volatility and pay up that creates trading opportunity for us. And as Lisa mentioned, our agency portfolio turned over a lot in the quarter. Pay-up performance and mortgage performance was quite strong in April and we saw a book value increase of about 3% in the month.

Let's look at how the portfolio evolved in the quarter. Despite trading actively, we didn't make any real big changes in portfolio composition. As you can see on Slide 12, we increased our agency coupon by over 15 basis points. And as you can see on Slide 11, we added more reverse mortgages and initiated a position in 20-year mortgages.

The portfolio size and types of prepayment stories we favored didn't evolve much. One nice thing is that we were able to both increase the average maturity of our repo and at the same time lower the average rate as shown on Slide 16.

Our outlook going forward is that we think the market belief that the Fed can extricate itself seamlessly from QE3 may get tested sometime in Q3 or Q4. So, we may see some greater opportunities caused by interest-rate volatility. While we expect prepayments to remain low by historical standards, we do expect an increase. For many mortgage originators, it's a matter of survival. Their fixed costs are simply too high to be profitable at the Q1 volumes we showed on Slide 8. We think the reaction from the mortgage banking industry will be increased competition for loans, slightly looser underwriting standards and continued industry consolidations. Fortunately, for the industry, mortgage rates are already over 25 basis points lower than where they ended last year and that coupled with the usual seasonal increases in home buying activity should lead to more production in Q2 and Q3 than what we saw in Q1. That increase in supply, combined with further Fed tapering, should create a somewhat less supportive environment for agency MBS, which may create some fallout and lead to some great investments.

With that, I'd like to turn the presentation back over to Larry.

Thanks Mark. As you can tell, we had a solid, even if a somewhat uneventful first quarter. We stuck to our knitting. We enhanced our portfolios through active trading and we hedged our interest-rate risk in the same disciplined manner that our shareholders have come to expect. As a result, we continued to increase our net interest margin and core earnings and this led to an increase in our dividend.

This past quarter was probably the first one since our IPO where most of our residential mortgage REIT peers actually had higher absolute economic returns than us. Remember, however, that just about everything went right for them last quarter. Long-term interest rate declined, volatility dropped, and prepayments remained subdued.

Looking ahead, we really believe that the market may have gotten too complacent here. It is highly probable that later this year the Federal Reserve will no longer be a net purchaser of agency RMBS. That will surely create some very different dynamics. It's been over 1.5 years since the Fed has been dominating the agency MBS market and the market, frankly, has probably gotten more used to that than it realizes. People have such short memories, which is truly a paradigm shift when the Fed initiated QE3 and it's just too early to say that the MBS landscape won't change drastically when QE3 ends.

Meanwhile, the bond market is not as deep as it looks. The big Wall Street investment banks certainly won't get in the way of a big move. As we saw in 2013, the large bond funds with their daily liquidity don't dampen volatility anymore, but instead they actually contribute to volatility as daily redemptions and to snowball following market down drafts. Of course we can't say for sure that there will be dislocations, but we can say that if there are dislocations, we plan to capitalize on those just as we did last summer thanks to our disciplined hedging program and disciplined liquidity management.

One market that we are keeping a close eye on for future opportunities is the MBS derivative market, which includes IOs. As you may know, IOs, whose prices generally increase as interest rates rise, can be an extremely efficient tool in managing interest-rate risk. A relatively small amount of IO can lower the portfolio's risk to rising interest rates as much as a relatively large number of long maturity fixed pay interest-rate swaps. And if priced right, the IOs can do this with much less drag to core earnings in those interest-rate swaps.

As you can see on our portfolio summary on Slide 11, as of quarter-end, we only had around $16 million market value of agency IOs. These IOs had an average duration of negative 24 years, which means that they were replacing the risk of about $45 million of 10-year swaps. While a number of sectors within the IO market are a little pricey right now, we believe that any big rate movement, whether up or down, will probably cause the IO market to loosen up, and we'll be ready to increase that portfolio when the time is right.

This concludes our prepared remarks. Operator?

(Operator Instructions). Douglas Harter, Credit Suisse.

This is actually [Tefuma] on for Douglas Harter. You know, just wondering. We've obviously seen a couple of quarters where your core earnings are pacing the dividend there. Just wondering at what point we start to see some convergence there? Is that debt the core that you are printing today kind of reflective of the true earnings power of the portfolio?

Yes, well, obviously, that's going to vary from quarter to quarter. We do you know -- do you want specifically our core earnings as opposed to regular earnings?

Correct.

Right. Well okay so.

Whatever is the best metric that you guys look at for the dividend there.

Right. Yes. So I would say it's a mix of both, but I would say core earnings is really what we look at more, weighted a little more heavily. So yes, it has -- core earnings has outpaced the dividend. We are trying to be conservative with the dividend. The dividend, you know, only is required by REIT rules to match our taxable income. So, if we can manage our taxable income in a way to keep it a little bit below the core earnings and yet at the same time have a dividend which is an attractive yield, we think that's the best of both worlds. If the taxable income sort of gets ahead of ourselves, then we obviously will need to increase that dividend or pay a special dividend. But we'd rather not do that because we are also looking at regular earnings, which is, as you know, for us, is fully marked to market, so that sort of gets back to book value, and we want to try to maintain a stable book value over time as well.

So it's a bit of a balancing act. You know if we were just basing it on our core earnings, then we would be increasing the dividend, but we are not. We're sort of balancing core earnings, taxable income and economic income all at the same time.

Great. That's really helpful. And then just secondly, just wondering what your comments are when you look at your outlook for the pay ups in the portfolio there, especially in light of what we saw coming out of GSEs realizing some of the record warranties -- maybe if you can comment on that a little bit.

Yes, this is Mark. You know, that one slide we had that show that refis, new home sale purchases, existing home sale purchases are all at really low levels. And you can look at one of those time periods only -- we only had data back to 1999 but the other one uses data back to like the 1980s or the 1960s. If you look at like new home sales for example, those aren't adjusted for population. Those things are at levels where they were in the 1980s. If you adjust for population, we are back to where we were in the 1960s. So, I think that you're going to see some improvement on all those metrics. Right? A little more refis, more new home sales, more existing home sales, which is going to cause more prepayments as well as just more turnover.

So, I think the combination of less Fed buying activity, more supply, and an uptick in refis is going to be supportive for a lot of the pay up stories. You know, some of the stories have done extremely well. Like there is that one graph of the story, appreciating 1 point since the beginning of the year, and some of that was behind the strong April we had mentioned, up about 3%. But there's still a lot of these pay up stories that definitely have room to appreciate. So, give us a longer time period on these things. I think there can be further gains.

The other thing is that when you talk to mortgage originators, the first quarter of this year was as tough an environment as most of these people have ever seen. You know, they have relatively high fixed costs, so they have to get aggressive on every type of production they can just to survive, and you are seeing that now. You are seeing a little bit of loose together credit box and you have all these comments today from Mel Watt about potential things the GSE's can do. So clearly I think people are concerned about the very low levels of new home sales and want to see if there are policy things that can be done that will spur some activity.

Great. Thanks guys.

(Operator Instructions). Steve DeLaney, JMP Securities.

Thank you. Good morning, everyone, and congratulations on a good start to the year. Mark, you mentioned Mel Watt. We had the GSE scorecard this morning, came out in the speech he gave at the Bookings Institute. I thought the most specific I guess and maybe impactful point was tripling the amount of risk transferred to the private sector up to $90 billion in 2014. And we are well into the year here to be tripling it versus last year. It doesn't appear that, in EARN, that you've participated in any of the stacker or cast deals thus far. I did see there's 2.5% in other nonagency. Is any of that referencing these GSE risk transfer notes?

We have not participated in those deals. When we look at the pricing of those deals, they make absolute sense to us why guys like Mel Watt want to increase the size of them. They are getting tremendous pricing on those. Really if you lay the stacker spreads versus what the G fees are, the government is able to insulate themselves from a lot of downside on their guarantee book without giving up much of the spread they are getting on G fees, so I think it makes a lot of sense. You know, I just think also too his comments about not changing loan limits. It just seems like you're going to be with somewhat status quo and then sort of changing things at the margin. So, yes, we have not participated in those deals because the way we look at them, we think we have better opportunities in other sectors of the nonagency market.

Right.

Of course, you know, if that increased supply changes the pricing significantly, that could change.

Exactly. That's where I was going, that they have tightened tremendously and you have to put a lot of leverage to get anything close to a double-digit yield or a high single digit. But just wondering if maybe this additional supply could create an opportunity. And a nice feature of course is that they are floating-rate assets.

Yes. No, absolutely, yes. If those things were to get in this location there and cheapen up when you see some issues with the cash flows on any of them that cause some idiosyncratic price moves, that could definitely become an opportunity.

Okay. Moving to the agency portfolio, it does seem we are in, almost in a kind of a little sweet spot or calm this year and mortgages have certainly performed very well year-to-date. But, I did take note to your caution that as we move to taper coming to conclusion and people start thinking about cost of carry versus what the outlook for Fed funds might be, that we could get some cheapening of the basis as the summer goes on. And I'm really thinking about spread widening, because you are pretty darn well hedged up, it appears, from just an interest rate risk standpoint. But what specifically, if you saw and you thought spreads blowout 20 or 30 basis points, what types of things might you do to try to protect book value in that kind of scenario?

One is you can sell assets, right? Sell, assets and receive on swaps, so shrink your outright spread duration in mortgages. The other thing is you can sell TBA.

Yes.

If you look at how we did you know June, July, August of last year, that was -- even if you look at bond market selloffs over a long period of time, that was a very violent selloff right?

Yes.

And we did a good job protecting book value. So, I don't think -- I don't anticipate that kind of volatility, but I definitely think you've seen a pattern before that a rise in rates leads to bond funds, money manager redemptions. Days sales is something Larry alluded to in his comments. They sell, and liquidity and capital provided to these markets by the primary dealers is not what it used to be. So a lot of big customers sell. Things are going to widen and things are going to go down in price and you're not going to have, I don't think we're going to have primary dealers stepping in and really being the buffer. So you know, we watch that very closely.

Yes, you know, we have had our percentage of our interest rate hedges on a duration-weighted basis that are in TBAs stead of close to a third. Right? So we are hedging about a third of our interest rate risk with being short TBAs. That's pretty high I'm sure relative to the peer group, but that's actually not that high for us. We could easily dial that up to 50% or even more. So that is really the main way I think if you -- for us to get into a defensive mode very quickly, that would be a very, very easy way to do it.

That's helpful guys. And I didn't know you had that kind of flexibility, given the REIT income test, the ability to go up to the 50% of your total hedges.

Yes, it turns out that everyone is really comfortable and has been, and so for years now that a short TBA position is basically no -- is as good as an interest rate swap or as valid as an interest rate swap in terms of hedging the risk that rising interest rates will increase your borrowing costs. So, because obviously if you are short TBAs, you'll make money and that income can be used to offset your higher borrowing costs so interest rates rise. So everybody has gotten comfortable with that and so we take full advantage of that.

And one last thing, Larry. Thank you for that, but one last thing. We note -- you've got a public document out there, an S-11 filing from late March. One thing that we've observed in the last couple of weeks is there's been sort of a resurgence in relatively small offerings of either perpetual preferreds or longer-term notes we call baby bonds. I'm just curious if you have your eye on that market and if it's possible that an instrument like that might be available to you to just defer the time in which you may might need to come to market with another common offering?

Right, I mean we are not -- that's not something that we are actively looking at right now. I think the pricing, especially for some of the smaller companies that you've seen on those types of instruments, has been we think pretty unattractive.

Yes. Near 8% I think.

Yes, some of the larger companies -- some people look at it, it's all different stock price and it's baby bonds, preferred. But some of the much larger companies have gotten more aggressive pricing. Even then I'm not sure that it would make sense for us, but given where we borrow, we are not -- I think we don't have -- just to increase our asset base per se is not by issuing some sort of unsecured debt or some sort of preferred or convertible instrument. That's not something that we feel is that important, so that's not something that we are really looking at that closely right now.

Well, it also says, tells me that you are -- while growth is something that I'm sure you'd like to accomplish, managing the portfolio is first and foremost and if the market gives you the opportunity to raise more common and the market is attractive, you will do it but you're not going to force it. Am I reading you right?

Oh yes. We are, obviously, we are at a big discounted book. So we are nowhere near where we could even start thinking about that. And that's okay. We've got lots of things to do here. And we are patient, as you know, so we'll wait for the right time.

Thanks for the comments. I appreciate it.

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