Ellington Credit Co (EARN) 2014 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 2014 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 opened for your questions following the presentation.

(Operator Instructions)

It is now my pleasure to turn the floor over to Lindsey Tragler, Vice President of Investor Relations. You may begin.

Thank you. 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 safe harbor provisions of the Private Securities Legislation Reform Act of 1995.

Forward looking statements are not historical in nature and will be identified by words such as believe, expect, anticipate, estimate, project, plan, continue, intend, hope, 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 under item 1A of our annual report on form 10K filed on March 21st, 2014, forward looking statements to a variety of risk 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 forwarding looking statements whether as a result of new information, future events or otherwise.

I have with me today on the call Larry Penn, Chief Executive Officer of Ellington Residential; 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 Lindsey. Once again it's our pleasure to speak with our shareholders this morning as we release our second quarter results. As always we appreciate your taking the time to participate on the call today.

First, a few highlights. We earned $11.1 million or $1.21 per share on a fully marked market basis in the second quarter. We maintained our $0.55 dividends which equates to a yield of 11.8% based on June 30 book value.

We're a yield of more than 13% based on yesterday's closing price. For the first half of 2014, earnings per share totaled $1.51 exceeding our $1.10 in dividends paid by a comfortable margin.

In our agency portfolio, our holdings of higher coupons specified pools continue to perform well during the second quarter. And as usual, we actively traded our agency portfolio to further enhance its composition and generate trading profits with 30% turnover during the quarter.

Our non-agency portfolio contributed positively to our results benefiting from tightening spreads and strong demand for higher yield and fixed income products. looking forward, as you'll hear from Mark, we've seen some positive develops in the market already in the third quarter, especially, as the Federal Reserve continues to phase out it's quantitative use in program.

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 positioned our RMBS portfolio, and what our market outlook is.

Finally, I will follow with some additional remarks before I'll bring the floor to questions. As described in our earnings press release, we have posted a second 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 will be helpful if you have this presentation in front of and turn to slide four to follow along.

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

Thank you Larry. Good morning everyone. In the second quarter we generated net income of $11.1 million or $1.21 per share. Our net income for the quarter was composed of core earnings of $6.8 million or $0.75 per share.

Net realized and unrealized gain from mortgage-backed securities up $25.8 million or $2.82 per share. And net realized and unrealized losses on our interest rates hedging derivative excluding that portion which is related to the net periodic costs associated with our interest rate swaps up $21.5 million or $2.36 per share.

In the first quarter, our core earnings were $7 million or $0.77 per share and our net income was $2.8 million or $0.30 per share. The decline of $0.2 per share of our core earnings was mainly due to a drop in interest income.

In the second, interest income related to catch-up premium amortization was negligible where as last quarter it was approximately $300,000 or $0.3 per share. As a result our weighed average portfolio yield declined five basis points of 3.43%.

However, while our net interest rate percent was flat quarter over quarter, our cost funds declined 4 basis points to 1.1% causing our net interest margin to drop by 1 basis point to 2.33%. Notwithstanding the media speculation about the potentially declining availability of repo financing, we continue to find it to be readily available with both long standing and new org. counterparties.

Thanks to increased competition among dealers we are continuing to see a decline in our borrowing costs. I mentioned a minute ago that our cost of funds fell 4 basis points during the quarter.

This drop was in part driven by 2 basis point decline in our average repo financing weight to 0.33% with the remainder resulting from a 2 basis point decline in interest expense relating to our interest rate swap. The size of our portfolio didn't change much quarter over quarter but we did turn over approximately 30% of our agency RMBS holdings as measured by sales and excluding principal pay down.

Turnover in our non-agency portfolio was less at only 6% for the quarter. While both portfolios benefit from active management, the degree of turnover can vary from period to period.

Weighted average book yield on our non-agency holdings actually increased to 10.6% from 10.4% as actual and projected cash flows on the portfolio increase. We ended the quarter with a total RMBS portfolio valued at $1.34 billion up slightly from the first quarter.

Our outstanding borrowing was essentially unchanged but as our equity increased quarter over quarter, our debt to equity ratio declined from 7.8 to 1 to 7.5 to 1. As I had mentioned declared and paid a second quarter dividend of $0.55 per share; unchanged from our first quarter dividends.

We estimate that our year to date taxable income is slightly ahead of our year to date dividends. Lastly, at the end of the second quarter shareholders equity was $1.71 million or $18.71 per share an increase of 3.7% from $165 million or $18.05 per share at the end of the first quarter.

Our economic return on book value for the quarter was 6.7% and with that I'll turn the presentation over to Mark.

Thanks Lisa. Agency mortgage strategies had a few important tailwinds this quarter. First, interest rate in volatility was low and interest rates gradually declined inducing some cash that had been on the side lines back into the mortgage market.

Prepayments were low, manageable and reasonably predictable. After several months of benign prepayment, investors began pricing in the expectation of these -- of these low prepayment volatility levels into the mortgage market hoping to support assets prices.

Mostly importantly supply of newly originated pools with low and absolute terms and much lower than market expectations. And against -- and against the back drop of very limited supply Fed purchases, even thought they weren't [defining] trajectory were still impactful.

In this environment our interest rate hedge strategy still generated significant returns. Across fixed income markets liquidity has been declining while declining liquidity is challenge it also brings trading opportunities that benefit our active style.

Our non-annualized turnover was 30% this quarter because we saw many market inefficiencies and miss-pricings that our active strategy enabled us to capitalize on.

Even though general prepayment levels have recently been low, looking more closely at the June, July prepayment reports there've been a few coupon and production vintages that actually been prepaying faster than expectations. Because the TBA market is the cheapest to deliver market, the fastest paying cohort has potential to depress TBA pricings even for a coupon with many slow paying pools.

In many coupons, this dynamic has been mass by the Fed's complete indifference to prepayments [to be done] their investments. By looking at the coupons that Fed no longer purchases you can get a glimpse at how pricing may evolve as the Fed's impact on the market continues to decline.

If you look at slide seven, you can see that TBA rolls are trending lower. Fed purchases are less than half of what they were at the start of the year. There's some coupons like four and a half that the Fed doesn't buy at all anymore.

Then you point after the dark blue line. The Fed no longer buys these. The Fed's previous purchases in four and a half which took so many of the less desirable pools out of the market have certainly helped the quality of remaining tradable float in the coupon.

But there's some bigger balance -- high FICO, [loyalty], -- these pools are created with unfavorable prepayment characteristics and now have to find a home with an investor other than the Fed. The roll cheapens up and this roll cheapening has a ripple effect.

Let's look at slide eight. This is an example of the ripple effect. It's regression of the monthly value of the Fannie 4.5 roll versus the path on low loan balance pools.

The lower the roll goes the more incentive there is to buy the specified pools. The rolls can be pushed down by a relatively small amount of the outstanding balance of the coupon. This can be fairly dramatic.

These pay ups in-ticks went from low 30s to low 50s and this can keep going. So far prepayment [speeds] have generally been very well contained.

Last year, these pay ups were over 150 ticks. So now, with less Fed buying, some other investor has to be the buyer with the most prepayment sensitive slices of mortgage production. But those other investors are generally much more concerned than the Fed about negative [convexing] and prepayment risk.

So here's how the ripple effect works. The Fed stops buying or buys less of a coupon, as usual there are always new pools or pools originated with unfavorable prepayment attributes but the Fed doesn't buy those pools now so these pools enter the tradable float of the coupon.

Is this subset of pools the cheapest to deliver pools with the most unfavorable characteristics that set the TBA price in roll. This becomes the bench mark against which specified pools are compared and in many instances, because they're supposed to be payment fees the specified pools offer better month to month carry than rolls of the generic TBA.

This is a gradual process but it's been noticeably happening in four and a half and we'll being to see it in other coupons overtime. This is why the length of time that the Fed reinvest pay downs after they finish tapering is still critical and is a big source of uncertainty for the RMBS market.

The Fed has not given clear direction on this. Even after the Fed is done tapering, for the period of time that they are still reinvesting their pay downs they keep many of the worse newly produced pools out of the float.

The importance of the Fed isn't only the amount they buy, but also the fact that they aren't buying exactly the kinds of pools that most -- that they are buying exactly the kind of pools that most other investors don't want. And could actually Fed buying be the marginal pool for determining TBA prices and low levels?

Mortgages obviously performed well this quarter but even with that performance adjusted for current levels of implied volatility and prepayment risks, they still look like they offer good relative value to investment grade corporate.

On slide nine, we show the [OAS] of Fannie 3.5 which is the blue line with this Y-axis scale on the left. And the maroon line is the OAS of the intermediate corporate bonds in the Barclays US aggregate bonding mix with its Y-axis on the right. The tightness of corporate credit is one of the main reasons mortgages have attracted so much capital this year.

Given that Fannie and Freddie are in conservatorship, the major difference between agency RMBS and treasuries is the implicit call -- is the implicit call option in RMBS. Meanwhile the main differences between agency RMBS and corporate bonds are the call options in the RMBS and the credit risk in the corporate bond.

The value of the call options is the function of two factors. First, how volatile will interest rates be? In other words, how likely is it that the option [or short] will get them money?

And second, if the option gets in the money, how efficiently will it be exercised? Well, for the first two quarters of this year, interest rate volatility was low and prepayment, the measure of how efficiently mortgage holders exercise their call option was also low.

So that was a great fundamental backed up for agency mortgages. Low of the levels of volatility and a benign prepayment environment are not things we think would exist in perpetuity. We're positioning the portfolio to try to protect book value should either or both of these change directions.

We have also used a run up in certain specialized pool pay-ups to monetize some gains in our holdings, and we see more attractive holdings elsewhere. In of terms of how we managed our portfolio this last quarter, we traded actively but did not make any large changes to portfolio compositions.

We added some 15 year prepayment protected pools. We [below] rolls they would drop and pay-ups would increase. That scenario has played out nicely since quarter end. We took some gains on some 30 year pools. We also took gains on some reverse mortgage pools.

The portfolio that we bring into the third quarter consists primarily of pools of loan balance related or MHA related prepayment protection. In our opinion, these are the two most reliable forms of prepayment protection currently available.

I believe we are well positioned to whether an increase in prepayments or interest rate volatility. With that I'd like to turn the presentation back over to Larry.

Thanks Mark. While we're pleased with our second quarter results, looking at returns from this one three month period alone doesn't give a complete picture.

May 1 marked our one year anniversary as a public company. We're extremely pleased without strong consistent performance during our first year and in particular our relatively stable book value during the tumultuous period for the agency RMBS markets.

For the past five quarters, including the quarter when we went public, we've delivered an economic return of 6.6% while the average economic return for our agency [re peers] over the same period is actually negative. Our out performance was driven by active trading and dynamic hedging which enabled us to avoid the sizeable book value decline suffered by many of our peers in 2013.

Because of the way we manage risk, we won't be the highest flying mortgage rate when interest rates fall but we believe that we'll benefit from significantly more down side protection than our peers when interest rates rise.

Looking forward we see the potential for increase volatility as a notable and perhaps underappreciated risk.

Dealer risk appetites and balance sheets are now much smaller than they use to be and the Federal Reserve is quickly phasing out quantitative easing. It's our few that the recent lack of volatility has lulled the market place into a false sense of security and it is masking what is actually a much shallower vulnerable market than what might appear on the surface.

We believe that it's likely that any sort of interest rate or prepayment shock will bring numerous dislocations and inefficiencies and therefore many opportunities for us.

As I mentioned last quarter, while most of our capital is still deployed in agency specified pools, we're always keeping a close eye on the MBS derivatives market in particular [IOs] which when priced right, can not only be efficient tools for managing interest rate risk but at the same time excellent generators of risk adjustor returns in their own right.

On slide 11 you can see that at quarter end, we had about $14 million market value of IOs down from almost $16 million down at the first quarter. Our current IO holdings are low because pricing levels are rich right now but we believe that any significant interest rate movement whether up or down, will likely make IO valuations more attractive.

And we'll be ready to increase our holdings there when the opportunity arises. This concludes our prepared remarks. And we're now pleased to take your questions. Operator.

The floor is now open for questions.

(Operator Instructions)

While you pose your question, we ask that you please pick up your handset to provide optimal sound quality.

(Operator Instructions)

We do have question from the line of Trevor Cranston with JMP Securities.

Hi. Thanks and congratulations on a good quarter. I guess the first thing, you know you guys talked about the kind of underappreciated risk of increased volatility.

There's obviously different ways you guys can protect yourselves against that. So I was wondering if you could just give a little bit more color kind of on how you guys out together your hedge positions when you're thinking about kind of being short TBAs versus more swaptions and how that plays out in your portfolio.

Hi Trevor it's Mark.

Hi Mark.

So we use both tools and what we do is we try to keep the amount by which the duration of the portfolio changes for given interests rates shift say 10 basis points shifts or so within some manageable band.

So really a -- three tools to manage that. One tool is swaptions. The other tool is being short TBA mortgages because the TBA mortgages have the worst volatility exposure in the specified pool so by short them -- by shortening them you're buying back some volatility.

And the third thing, it's just, you know, rebalancing the portfolio periodically as the market moves. So one aspect of the second quarter which I think with helpful to returns, helped us as well as I'm sure you know our peer group was the fact that in the second quarter there was not a lot of big interstate movements.

So it didn't require many portfolio adjustments. then really contrast that to second and third quarter of last year where you saw this vital sell off in the market and then a rally back so a lot of people sort of repositioned their portfolio when rates kind of hit a high and then missed out on some of the price appreciation they could have had if they had maintained their portfolio the way it was.

So it's really those three tools and we sort of are adjusting you know the relative importance of those tools as a function sort of market dynamic.

Got it that's helpful. The second thing, you know Larry commented about the IO market at the end of the call there. And I was curious you know seems like IO valuations have remained pretty elevated even as mortgage rates have come some.

So I wondering if you guys could just comment on what you thinks driving that and you know if you think kind of we need to see a new -- a break down to a new kind of lower mortgage rate before the IO markets start getting concerned about higher prepays.

Yes, I think -- this is Larry. Yes I think that we do need a move. I think that what's driving the rich valuations frankly is performance.

Prepayments have been muted. We've been now in a range you know. We've been range bounded interest rates. We haven't seen a big break out of repayments so I think those IOs on an unhedged basis certainly are going to be spitting out huge carry in the meantime.

So you know we believe that the way that we look at the world which is on a relative value and on a option adjusted standpoint, we think that this is not a good entry point. But on the other hand if interest rates rise we think that those people who are unhedged will you know take profits and that will create some selling pressure.

They'll basically extract it from the trade what they were looking for and if the rates fall, they're you know obviously at that point (technical difficulty) shock and again those are unhedged are probably going to be selling for worse reasons.

But as long as we stay in this range and as long as prepayments are relatively benign, which of course is related to staying within the range, they're probably not going to be a lot of cracks in the IO market.

Got it. When you guys look at kind of projecting refinancing activity, is there kind of a key level you guys think about for kind of the conforming mortgage rate that you think would start to trigger some more meaningful activity?

Well I think it's really two things. So one is you have to look at the distribution of note rates in the existing mortgage stock. That's one of the reasons why the refi index has been so low right now.

You had no -- even though rates are low now you had a lot lower rates in 2012, 2013 so it's shifted a lot of current mortgage holders into you know [350] to 4% 30 year note rates, so they don't have an incentive. So that's one big chunk of the population that has no incentive to refi and that keeps refi index low.

And I think you know at least a 25 basis point drop to really change -- to really move a significant number of borrowers into a rate environment where they have sufficient incentive to refinance. But if you look at individual coupons and individual cohorts, there you're already starting to see activity.

So 2014 -- 2013 Fannie 4.5 to paid relatively quickly. So even though that's not a big enough cohort to really raise the refi index a lot an individual pool base and on a coupon basis it can be impactful on its price.

Got it. That's helpful. Thanks a lot for the comments.

Thanks Trevor.

And our next question comes from the line of Jim Young with West Family.

Hi. You mentioned that on the reverse mortgages that you took some profits given the timing of spreads. I'm just wondering how you're thinking about that market at this point?

What kind of returns you think you can generate in the -- from the reverse mortgages?

You know when we first bought those they looked to us when we valued them -- you know they don't have a lot of them negative [convexy], they don't have a lot of optionality in them. It looked like they were somewhere 85 basis points to 90 basis points off the curve which was -- that's wide for you know agency credit once you take into account the prepayment risk.

And they've come in now to say 55 basis points or so. So they don't look to us super expensive when you look at every part of investment grade fixed income. You know that tightening probably matched by what you see in investment grade corporates or what you've seen you know on the Freddie K series bonds.

It's just for us -- we think additional tightening from here is going to sort of be hard fought for them and a slower [slog] so we'd rather sell them and get into some other kind of pools where we think you're going to have more pay of volatility. So you know I don't think they're a bad investment right here at all but just -- did kind of achieve the spread target we had set form them.

And you know we think there's probably some more opportunities looking at pools that we can not pay a lot to the prepayment protection now but might you know have a significant increase in value in the future.

And they're also -- part of the reason why they were cheap and still trade wider is liquidity. They're not nearly as liquid as 30-year or even 15-year mortgages.

So you know we feel that if there is any selling or increase supply that could put pressure on that sector pretty quickly. So, you know we just decided to take some profits there.

There are no further questions at this time.

Ladies and gentlemen this concludes Ellington Residential Mortgage REIT's second quarter 2014 financial results conference call.

Please disconnect your lines at this time and have a wonderful day.